How to Unfreeze Bank Lending

The government should guarantee interbank activity.

The most pressing problem for American companies and cities is the unwillingness of financial institutions to make short-term loans. Banks are reluctant to lend to other banks, as shown by the huge spread between the interest rate on interbank lending and the yield on three-month Treasury bills. At the same time, money-market funds are shying away from short-term commercial paper of money-center banks and large companies in favor of U.S. Treasury bonds.

As a result, many American companies are facing serious challenges in financing their inventories and payrolls. Even triple A credits like General Electric must pay very high rates to sell their three-month commercial paper. Similarly, many local governments must pay very high rates to obtain short-term tax-exempt financing. The yields of short-term paper from most municipalities are now running above 5% on a tax-free basis.

Unfortunately, federal purchases of troubled assets under the Economic Stabilization Act will take several months to generate more liquidity. The initial purchases are not likely to lead to more lending by the institutions willing to accept the conditions of the federal bailout. These conditions include giving stock to the federal government as well as limiting compensation and golden parachutes for top executives of an institution that sells more than $300 million in troubled assets to the Treasury. Accordingly, the sellers will be mainly weak institutions that will use the cash proceeds received from the Treasury first to cover their loan losses and rebuild their capital.

Yesterday, the Federal Reserve announced that it will buy at discount unsecured commercial paper from certain non-lending institutions. This is an important stop-gap measure. However, the ongoing needs of local companies and governments can be met only if they can borrow regularly from local banks.

To melt the freeze on short-term loans by banks, the federal government needs to reduce the risk of surprise from such loans. Healthy banks and money market funds are wary after the rapid demise of AIG, Lehman and Wachovia. Therefore, the Federal Reserve should guarantee most of the short-term borrowing of well-capitalized banks for a small fee.

Such a guarantee for interbank lending would be consistent with the widening government support of banks in Western Europe. This has been done already in Ireland, for example. At Saturday’s meeting of the G-7 finance ministers in Washington, the Fed should launch a coordinated program with European central banks in guaranteeing loans to their banks.

Here’s how the guarantee might be structured to dovetail with the federal bailout bill and constrain moral hazard. A bank could borrow up to a specified percentage of its tangible capital, with a Fed guarantee for a limited period such as three or six months. This limit should be designed to give enough time for new sources of lending to be generated by the federal purchases of troubled assets. The Fed guarantee would cover a large portion, say 90%, of the principal of these loans only in the event that the borrowing bank becomes insolvent. The non-guaranteed portion of these loans would give lenders the incentive to make intelligent choices and monitor the borrowers.

With this federal guarantee, banks will lend to other banks and the interbank lending rate will fall back to its normal level. Money-market funds will also buy the commercial paper of well-capitalized banks. In turn, these banks will have additional cash to make short-term loans. In this way, the current freeze on credit will melt into a new pool of liquidity.

Mr. Pozen is chairman of MFS Investment Management.

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