A Paradox for the Banks

The AP article, "Banks are pressured to hoard money and make loans" featured in Sarasota Herald Tribune illustrates how banks are attempting to juggle their role as a lender and their responsibility to adhere to government regulations. The paradox that the banks find themselves in is at the heart of the economic crisis. The Treasury has given the banks money for them to lend but the banks can't lend.

Why can't the banks lend even though the Treasury has given them the money to do so? It would seem the problem has a lot to do with another hand of the government. According to banking regulations established by the Federal Deposit Insurance Corp. (FDIC), banks must maintain capital equal to at least 12 percent of assets on their balance sheets. According to Greg Melvin, chief investment officer at investment firm C.S. McKee, "Two arms of the government are saying exactly the opposite thing -- it's ridiculous."

Absurd it this may seem, this is current situation that many banks find themselves in. On the one hand, you have the negative externality impacting the banks who in the past made bad loans and now find themselves having to adhere to strict FDIC regulations. On the other hand, banks are also the focus of positive externality in the form of government subsidies from the Treasury in order to make more loans available. The outcome appears to be gridlock.