John Judis and I have been debating this question around the water cooler for the past several months, so we figured we'd drag it into our pages. He went first last week with this rather compelling piece. Today, I pushed back here. Here's a flavor for what I'm arguing:
In mid-October, then-Treasury Secretary Hank Paulson forced nine of the nation's 20 largest banks to accept $125 billion in government money. Despite this increased capital buffer, the five biggest banks cut their lending by 16 percent (roughly $120 billion dollars) during the fourth quarter of last year, according to the Fed. The next 20 biggest banks cut their lending by over 4 percent ($9 billion).
John would probably say this proves his point: It must have been the weak economy, rather than insufficient capital, that led banks to contract credit even after receiving all that bailout money. But the evidence suggests the opposite: During the same period, the country's small and mid-sized banks (basically every bank outside the top 25) increased lending by about 5 percent ($27 billion). Presumably both sets of banks were facing the same economic conditions; only the biggest ones were hemorrhaging capital.
Also, I try to draw some attention to the next looming disaster in the financial sector, small and mid-sized banks. (Though I don't get into it, this touches on some of the issues arising from the expected collapse of CIT):
The big banks, with their massive investment portfolios and their large exposure to home mortgages, were most vulnerable to the initial financial crisis and to the residential real-estate bust that precipitated it. It made sense that they felt the strain first. For their part, small banks tend to be heavily invested in commercial real estate, which has faltered only in recent months as the financial crisis has spread through the economy and evolved into a deep recession. In a recent study of small and mid-sized banks, the Journal projected about $200 billion in total losses through the end of next year, with commercial real estate accounting for roughly half of that amount. If that estimate is right, the paper concluded, "more than 600 small and midsize banks could see their capital shrink to levels that usually are considered worrisome by federal regulators."
Now, even if you combine all the small and mid-sized banks in the country, they only account for about a third of the assets in the banking system. (The 19 stress-tested banks account for the other two-thirds.) The reason they're worth worrying about is that, relative to other banks, they play an outsize role in supplying credit to the economy. The mega-corporations that do business with the biggest banks have multiple ways to get credit: They can issue corporate bonds, for example, or participate in the commercial paper market (basically a way to borrow money from investors on an extremely short-term basis). These companies tap lines of credit with the big banks that service them only as a last resort. But most of these other options are closed to smaller companies.