A report released by the Special Inspector General for the Troubled Asset Relief Program (SIGTARP) reveals that the federal regulators tasked with ensuring banks were in solid capital position before leaving the program were bending the rules to allow many big banks leave before they properly demonstrated their fiscal strength.

The report, Exiting TARP: Repayments by the Largest Financial Institutions, details how and why banks rushed to exit the federal bailout program, and shows that regulators let them skirt important capital requirements.

TARP was passed by Congress in late 2008, and injected over $200 billion in capital into the nation’s most troubled financial institutions. 80% of this money ($163 billion) went to 17 of the 19 banks subject to the Supervisory Capital Assessment Program (SCAP), which “stress-tested the nation’s 19 largest financial institutions and estimated future losses, revenues, and needed reserves,” according to the report.

TARP Limited Executive Compensation

TARP had stringent requirements for exiting the program, especially for the big banks included in SCAP. Notably, banks were initially prohibited from exiting TARP within three years of entering. Banks didn’t like this because TARP imposed restrictions on executive compensation, and banks claimed that participation in the program carried a certain stigma with it, reports SIGTARP.

According to the report, these two factors motivated banks to rush out of TARP. Once the American Reinvestment and Recovery Act — the Stimulus Bill — passed, the banks had an opportunity — ARRA included provisions to allow banks to exit TARP before the three-year waiting period, so long as federal regulators gave their blessing. Nine banks quickly left the program, and returned to business as usual.

The remaining banks were not deemed ready by the Federal Reserve Board, and told that if they wanted to repay their TARP loans and exit, they had to raise $1 in common stock for every $2 they paid the Treasury for their TARP loans. According to the report, this provision was “based upon an assessment of the banks’ capital levels from the recently completed stress tests.”

Banks Repeatedly Weaseled Their Way Out

Bank of America, Wells Fargo, and PNC all requested to leave the program, but repeatedly “balked at issuing the amount of common stock required by regulators.” Instead they sought “cheaper and less sturdy alternatives,” like issuing stock as compensation to employees (instead of to the public) and issuing trust-preferred securities.

Banks expressed concern about diluting the value of their already existing stock, and the negative effects of issuing so much common stock at once, by so many banks. None of the offerings failed, despite how close together they occurred.

Eventually, regulators caved to the banks’ repeated requests, and allowed Bank of America and Wells Fargo to leave TARP with less capitalization and liquidity than necessary, at least by regulatory stress-test standards. Essentially, because banks wanted out of a program that limited executive pay.

The Inspector General’s report ends on a somber note. It points out that today, there are still several too-big-to-fail financial institutions that are too interconnected to fail without “serious consequences to the broader economy.” It goes on, “Unless and until such institutions, either on their own accord or through regulatory pressure or requirements, are restructured, simplified, and maintain adequate capital to absorb their own losses, they will pose a grave threat to the entire financial system.”

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