CHICAGO – Little political enthusiasm exists for further support to the banking sector. One reason is that banks that received money in the initial rescues do not seem to have increased their lending, without which monetary and fiscal stimulus are unlikely to be effective. For banks to start lending again, even more intervention may be needed.

To see why, we need to understand why banks are still so reluctant. One possibility is that they worry about borrowers’ credit risk, though this would have to be extremely high to justify the complete cessation of long-term lending. A second possibility is that banks worry about having enough resources to meet their own creditors’ demands if they lock up funds in long-term loans. But the many central bank lending facilities that have been opened around the world should assuage these concerns, especially for large and well-capitalized banks.

On the other hand, perhaps banks’ reluctance to lend reflects a fear of being short of funds if investment opportunities get even better. Citicorp CEO Vikram Pandit said as much when he indicated that it was cheaper to buy loans on the market than to make them. And buying may get cheaper still!

Consider, for example, the real possibility that a large indebted financial institution faces a run on its deposits, as Lehman did, and starts dumping loans onto the market. Not only will those loans’ price fall if only a few entities have the spare funds to buy them, but other distressed entities’ scramble to borrow also will make it hard for any institution without funds to obtain them. Anticipating the prospect of such future fire sales (of loans, financial assets, or institutions), it is understandable that even strong banks will restrict their lending to very short maturities, and their investments to extremely liquid securities.

This may also explain why markets for some assets have dried up. Some distressed banks clearly possess large quantities of mortgage-backed securities, and are holding onto them in the hope that their prices will rise in the future, saving them from failure. At the same time, buyers expect even lower prices down the line. While there is a price today that reflects those expectations, it is not a price at which distressed banks want to sell.

As a result, there is an overhang of illiquid financial institutions, whose holdings could be unloaded if they run into difficulties. For some, low prices would render them insolvent. For others, low prices would be a tremendous buying opportunity, whose prospective return far exceeds returns from lending today. Political exhortations to lend can have some, albeit limited, impact. Any voluntary resumption of lending will necessitate reducing both fears and potential opportunities.

Here are some ways to reduce the overhang. First, the authorities can offer to buy illiquid assets through auctions and house them in a government entity, much as was envisaged in America’s original Troubled Asset Relief Program. This can reverse a freeze in the market caused by distressed entities that are unwilling to sell at prevailing market prices.

The fact that the government is willing to buy in the future (and now) should raise prices today, because it reduces the possibility of low prices in a future fire sale. Moreover, once a sufficient number of distressed entities sell their assets, prices will rise simply because there is no longer a potential overhang of future fire sales. Both effects can lead to increased trade in illiquid assets today, and unlock lending, though this outcome may require significant government outlays.

A second approach is to have the government ensure the stability of significant parts of the financial system that hold illiquid assets by recapitalizing regulated entities that have a realistic possibility of survival, and merging or closing those that do not. For those entities that are closed down, this would mean moving illiquid assets into a holding entity that would gradually sell them off. One problem is that the public’s appetite for a bailout of the unregulated and hemorrhaging “shadow” financial system, consisting of institutions like hedge funds and private equity firms, is rightly small, yet it too can serve to hold back bank lending if a large proportion of the distressed assets are held in weak institutions there.

Perhaps, therefore, a mix of the two approaches can work best, with the authorities buying illiquid assets, which can help even unregulated entities, even while cleaning up the regulated financial sector, focusing particularly on entities that are likely to become distressed. This differs substantially from the current approach (in which well-capitalized entities are given even more capital), which does not deal with the overhang of illiquid assets that more distressed entities hold. Unless the regulated financial system is systematically audited, with weak entities stabilized through capital injections, asset purchases, or mergers, or liquidated quickly, the overhang of distressed institutions will persist, constraining lending.

One lesson from Japan’s experience in the 1990’s is that the sooner the authorities bite the bullet and clean up the financial system, the sooner the economy will be on the road to recovery. The longer officials remain paralyzed, hoping that the financial system will right itself, the higher the eventual cost of the cleanup will be.

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