How can banks best use TARP funds?

As the funds flow from the TARP to banks, people are heatedly debating how the funds should be used. The White House, of course, has already suggested that banks ought to use the funds to make loans. The Treasury Department has voiced similar sentiments, though it also blessed PNC's decision to use the money to finance its deal for National City.

So what to do? As of right now, banks have several options: 

• They can use the money to buy other banks. This seems like a decent option in some circumstances. If it will save an otherwise doomed bank, perhaps it is a really good use of TARP funds. If such a deal enhances the survivability of both entities, why not?
• They can loan the money. Of course, this would grease the wheels of the economy. But making loans in this environment is a bit tricky. The last thing you want is to make loans than end up in default. You can't expect banks to lower their lending standards. (Of course, scam-mortgage purveyors did just that).
• They can use the money to pay dividends. The Washington Post notes that U.S. banks are getting about $163 billion from the program and are on pace to pay more than half of that amount in dividends over three years. Galling? Well, Treasury says banks might not have participated if they imposed dividend restrictions. It may not be the best use of funds, but it does keep them operating as usual and put a floor (hopefully) under their stock prices.
• They can hoard the money. To some this is unconscionable, but let's think about this, the real focus was to keep the financial system working, more so than goosing the economy. From this perspective, hording the money makes some sense. It certainly props up key capital ratios, creating a cushion that should calm stock and bond holders. This may help borderline banks survive.
• They can use the money to pay large bonuses to executives and employees. As of right now, most top wall Street firms seem to be bent on making bonus payments, pretty much as usual, according to Bloomberg. Which is a PR debacle in the making. Politicians are already getting worked up about it. If a firm lost money for the year and is seen as really struggling, it would be god-awful to use TARP funds for bonuses. That just can't happen. For a company like Goldman Sachs, which made money, most of the bonus pool will have come from accrued earnings. Still, you can expect some controversy.

So how should banks proceed? Well, you would hope that banks balance all the competing interests and come up with a course of action that just might include all of the above. This begs for common sense. Banks have to understand the political and PR sensitivity of using TARP funds.

Does a bank really want to pay out huge dividends with the money? Probably not. Some have voluntarily suspended dividends, which strikes me as a decent approach. It would seem wise to at least reduce payouts. Similarly, do you want to pay outsized bonuses right now, given the political climate. The short answer is no. But there may be ways to rationalize promised payouts via deferred plans or stock plans.

And yes, we would hope that over time, banks would use the money to make more loans. Granted, this may take time. But not using any of it to make loans wouldn't seem right--over time. Surely, there are a few good credit risks out there for you. By the same measure, if the deal of a lifetime, the perfect fit were to crop up, using the funds for a deal would make lots of sense.

And here's another course of action: Refuse funds. If you are healthy, this may be the best option. This allows you to skirt these issues and hopefully, you're in this position.   

The bottom line is that taxpayers are now big investors. They want a decent return on the preferred shares Uncle Sam bought, which requires prudent use of bailout funds. This is where top CEOs, and directors for that matter, really shine. - Jim