By Trey Maust, an EO Portland member and CEO of Lewis and Clark Bank.

It was October 2005, and I had just resigned from my position as CFO of a US$250 million bank. I wanted to devote full-time efforts to form a new commercial bank headquartered in the Portland, Oregon, USA, metropolitan area. Times were good. As co-founder and the largest beneficial shareholder, little did I expect when we opened our doors on 15 December 2006 that the country was heading straight toward one of the worst environments this industry has seen in any of our lifetimes.

The current economic environment, including legacy issues from the unprecedented volume and loosening of underwriting standards of residential mortgage loans, is resulting in serious strains on the banking industry. Collateral damage from this is felt in the lack of availability of credit to businesses, both large and small. Are banks simply being conservative? Are they in survival mode? Let’s rewind the clock.

As recent as two years ago, credit losses were at historic lows and margins were favorable. Banks were concerned primarily with profitability, but more importantly, they were constantly pressured to maximize return on equity. The most common means of increasing return on equity was by rapidly expanding the loan portfolio, thereby building high-yielding assets and maximizing leverage on equity capital. This oftentimes meant loosening credit underwriting standards in order to compete with securitizations and other non-bank financing vehicles. By the time the national credit markets began to seize in August 2007, most banks found themselves with highly leveraged balance sheets supported by assets that, in some cases, were not of the quality seen in years past.

What many bankers lost sight of was the importance of equity as a cushion to absorb unforeseen portfolio and operating losses.  Because of pressure to maximize return on equity, significantly exceeding regulatory minimum levels wasn’t viewed as an efficient deployment of equity, particularly given how ubiquitous and cheap bank equity capital was in recent years. However, dropping below “well capitalized” status presents unwelcome restrictions on operations, the most crippling of which is lack of access to emergency wholesale funding (i.e., the bank becomes highly vulnerable to a liquidity crisis). Banks that fall below “well capitalized” are uncomfortably close to regulatory receivership or a forced sale to another financial institution.

Of the three regulatory capital ratios, the key ratio banks tend to focus on is “total risk-based capital to risk-weighted assets,” which is a regulatory capital ratio that incorporates the risk profile of the banks asset mix. The minimum for “well capitalized” is 10.0 percent.  For the past 15 years, the banking industry has averaged around 12.5 percent. This leaves very little room to absorb the sudden asset write-downs or operating losses experienced over the past year.

Fear is a strong motivator. Bankers are preserving equity capital at any cost, and many are doing what would have been unthinkable until now: deleveraging their balance sheet. I participated in a recent CFO roundtable and all but one bank in attendance were ceasing or drastically reducing lending activity, and in many cases, selling good-quality seasoned loans to “de novo” institutions who are still in growth mode. During the past 45 days, our bank has received multiple requests to purchase loans like this. Almost all are to businesses that would fit the demographics of those in EO, which leads me to believe that credit will not be readily available for small businesses at reasonable levels for at least another year or two.

Despite defensive actions taken by many banks, there is a high likelihood that we have only seen the beginning of a long line of bank failures, and even worse for the economy, the continued inability for many businesses to access credit. What the banking industry needs and what would free up banks to begin prudently lending is the ability to raise equity capital. Unfortunately, bank stock prices are at near historic lows and there is little desire to invest. While I am not a fan of a nationalized banking system, I do think that the most viable alternative now is preferred equity investments by the Treasury in healthy but capital-starved banks. Only then can we expect to see the availability of credit begin its slow march to normalcy.

Yes, we live in interesting times.