How Basel Worked Against TARP

In a post over at the Stash, Zubin Jelveh looks at whether TARP actually increased bank lending:

Banks did appear to use some of their TARP funds to increase lending. To arrive at his conclusion, Taliaferro compared different metrics of otherwise similar TARP and non-TARP banks in the months after the financial crisis began:

Based on a matched sample of participating and non-participating banks, of each dollar of new government equity they received, participants used roughly fifteen cents to support increased lending, while they used roughly sixty cents to increase their regulatory capital ratios.

This chart from the paper, displaying the fraction of TARP funds used for different purposes, shows that the average bank also directed some of their new capital towardsof their capital to boost earnings:

Excusing the typo, I think what Jelveh is driving at is that banks used TARP money in three primary ways: to increase lending, to pad earnings statements, and -- most importantly -- to boost their Tier 1 capital ratios.

Banks had to maintain high capital ratios to meet their Basel requirements, which uses a risk-weighting scheme to determine the required adequacy ratio. At the end of last year and beginning of this year, bank capital was decimated by the financial crisis, but banks still had to maintain their ratios. So as soon as they got access to capital from TARP they simply plugged the holes, which meant they had less cash to lend than they would have had if the ratio requirements had been temporarily relaxed.

That doesn't mean that they shouldn't have used any of the money to recapitalize. Of course that was need too. But 4 times as much TARP money was used to boost capital ratios than to actually get money moving through the system, which was TARP's ostensible purpose. So in a sense, Basel was working against TARP, and made it much more expensive for Treasury to get lending moving again. If regulations were countercyclical, this wouldn't've happened and TARP might have gotten much more bang for its buck.