Even Good Credit Gets No Credit Today : Economy: Banks, needing reserves, reduce lending even to solid businesses. The result is contraction, layoffs and no new investment.

A couple of weeks ago, Federal Reserve Board Chairman Alan Greenspan told the House Banking Committee that the recession was over, the economy had bottomed out and the signs of recovery were present.

The next day, a group of 15 business executives representing a broad range of New York and national firms met with Greenspan. They told him, one after the other, that things were getting worse, not better, and that they saw no signs of a recovery, at least in the Northeast.

The reason they offered for this assessment was consistent--the lack of available bank credit necessary to carry inventory, to invest in research and development of capital projects or to expand. Speaker after speaker told the same story, even though their businesses are very diverse. Solid, profitable companies that do not have direct access to the capital and debt markets and thus rely on banks for financing have seen lines of credit reduced or terminated, good loans--which were not in default--called, and access to new funding denied. The result is contraction, layoffs and no new investment, even though demand for the businesses’ products is there.

Most of the business leaders at the meeting also believed that they knew the cause of the problem. They blamed federal bank regulators who, as a result of the savings and loan debacle, have wreaked havoc on commercial-loan portfolios. Each of the business executives had heard the horror stories from his bankers. Loans that were perfectly good and approved by the regulators two years ago are now declared non-performing because new appraisals have devalued collateral. The banks are forced to set aside reserves against these loans, even though payment is current, thus reducing the banks’ lendable funds. Good loans are called and credit lines are reduced so that banks will have adequate reserves to absorb the writeoffs directed by the regulators. The best credit risks are penalized because the banks know these borrowers can repay, and banks need cash, not assets.

Could our banking system really be this upside-down?

A group of these bankers recently declared at an editorial board meeting that they were no longer running their own loan portfolios. All matters of business judgment had been cast to the wind. Long-term relationships, the partnership between banker and client, had ceased to matter.

The only thing that counted was whether a loan satisfied the bank examiners’ predetermined formulas and, if it did not--even if it was current and the borrower had been a great credit risk for years--the regulators forced the bank to declare the loan as non-performing and write it off.

And as real estate values have declined and new appraisals have been ordered, more and more loans have been declared non-performing, more commercial properties have been forced on the market to satisfy these loans, driving values down even further.

How, in this type of environment, could the recession end and recovery begin, Greenspan was asked.

Greenspan then did a rather remarkable thing. He agreed with the group that their perceptions were real and valid, that the bank-credit crunch was having a devastating impact on medium and small businesses that could not borrow in the market the way larger corporations do. He also said he now understood that the problem is particularly severe in the Northeast, though he assured the group that he had heard from business leaders all over the country about the same problem.

Greenspan admitted that the regulators had been overzealous and, indeed, pointed out that this past March the various agencies responsible for bank regulation had met and agreed to issue new guidelines to regulators encouraging the use of greater judgment in evaluating loans.

He conceded that he had no idea whether this directive had yet filtered down to the examiners in the field or whether it was having any effect.

But Greenspan was not prepared to place all the blame on the increasingly inflexible regulatory environment. He felt that “terrified” bankers were equally to blame. He said that decisions to call loans, even solid, performing loans, reflected fear by bankers that they were too much at risk. He said that, while the consequences of this fear were bad for the economy, he did not know what could be done to change it, other than to let time take its natural course. Over time, he said, bankers would lose too many customers and would have to get back into the commercial and real estate loan markets to stay competitive.

What is to be done? Clearly the answer is not simply to wait to see if the regulators get the message or the bankers get back their nerve. This is an unprecedented problem that is already costing tens of thousands of jobs, with more small businesses failing or contracting every day. The recovery will be slow and slight, if it happens at all, unless something is done to make available the credit that small- and medium-sized companies will need to ride out the damage of this recession and begin to rebuild.

The Federal Reserve, the comptroller of the currency and secretary of the Treasury must do more. They must send a clear and coordinated signal that more flexibility must be given to banks to work out problem loans. They must modify the way they are valuing real estate, so that loans don’t automatically become “bad” because of temporarily depressed real-estate values. They must give bank examiners incentives to exercise judgment in evaluating loans, to encourage economic recovery as the solution to strengthening bank assets. They may need to encourage Congress to put more flexibility in the timetable for achieving the newly mandated capital requirements for banks, so that a reduction in assets does not become the only means of achieving the targets.

The banks also must do their part. If the regulatory environment changes, they must provide the necessary credit to their good customers.

Finally, the President and Congress cannot escape their responsibilities.

Economic recovery depends on the health of the nation’s thousands of small businesses, which create the jobs that will turn this economy around.