Will TARP repayment kill the zombie banks?

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Use two buzzwords in a sentence and you're asking for trouble. But since $12.8 trillion of taxpayer money is at stake, it's a risk I need to take. The Treasury is poised to announce that it will let some banks that got Troubled Asset Relief Program (TARP) money -- JPMorgan Chase (JPM) and Goldman Sachs (GS) -- repay the money. The only problem with this is that such repayment will damage the zombie banks -- those that our tax money is propping up which would otherwise fail.

How will TARP repayment harm zombie banks? As I posted, it all comes down to money and people. Wall Street pays better than anywhere else on the planet. At least 60 percent of the revenue goes out to its employees every year. If Goldman no longer has TARP money, it could be free to pay its people as much as it wants without suffering the political pressure that comes from holding on to taxpayer money.

Free from those pay limits, the TARP-free banks would have an enormous competitive advantage over the rest. That's because they could offer big pay packages to the top producers at the zombie banks. This would leave the zombie banks with shrinking revenues and high costs -- a recipe for slow-motion financial failure. This leaves soon-to-be-appointed Wall Street pay czar, Kenneth Feinberg, with an important decision: Should banks that repay their TARP money be freed of pay restrictions?

The answer may be 'yes' if those same banks also swear off of the $1 trillion in emergency loans they've gotten from the Federal Reserve and the FDIC. If Goldman and a few of its peers become TARP free but still use these government loans, it seems to me that they should continue to be subject to pay limitations.

If they pay off all the government loans as well as the TARP, then I think they should be free to start poaching talent from their weaker rivals. Of course this will leave the U.S. with the challenge that it has yet to face squarely -- whether to kill the zombie banks quickly and completely or let them die a gradual and lingering death. Because once the government-free banks start to hire the zombie banks' producers, those are the only two likely outcomes.

I don't think the U.S. has figured out who will pay the enormous cost of a quick failure. When Japan got into a similar mess in the late 1980s, we told it to force its banks to write off the bad loans but it declined to do so. Now we are refusing to follow that same advice we happily gave Japan back then. So we risk going the way of Japan, which has spent 20 years in economic purgatory.

Unfortunately, the U.S. is missing the key point. People will do what they're paid to do. If you pay Wall Streeters to bring in big deals fast to make tens of millions in annual bonuses, that is what they'll do. If you put those bonuses in escrow and pay them out to the bankers only if those deals make money for investors -- using the escrow to repay investors' losses if the deals go bad -- then they'll bring in fewer good deals to maximize their incomes.

To fix the system, Feinberg should change Wall Street pay along these lines -- this will make Wall Street a smaller place but one that does a good job of financing technology-led growth. And that -- rather than paper entrepreneurialism -- is what American capitalism should be all about.

Peter Cohan is president ofPeter S. Cohan & Associates. He also teaches management at Babson College. His eighth book isYou Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He has no financial interest in the securities mentioned.

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