There are tantalizing signs that the worst of the disastrous credit crunch may be over. The most tangible evidence can be found in the latest earnings reports from some of the U.S.’s largest banks.

With a few exceptions, financial institutions such as JPMorgan Chase & Co. and Wells Fargo & Co. reported increases in lending to big businesses and, to a lesser extent, to consumers. Since consumers power growth, making up about two-thirds of the U.S. economy, their ability to get credit may determine whether the fragile recovery endures.

There are several things regulators and banks can do to ensure that the lending revival doesn’t fizzle. Although many bankers might disagree, regulators should continue to press banks to increase their capital. As we have argued before, more capital gives lenders a greater cushion to absorb losses, thus lowering risk to the financial system and the economy.

One of the reasons the credit crunch was so severe is that huge losses ate into banks’ capital, which was too thin before the recession began. This robbed them of their ability to keep lending. At the moment, the 24 banks in the KBW Bank Index have average tangible common equity, the hardest measure of capital, of 7.4 percent, which puts them on much sounder footing than before the crisis.

Capital Beauty

The beauty of capital is that the more of it a bank has on hand, the more loans it can make. The U.S. Treasury has estimated that every $1 in capital can be used to create roughly $10 in loans. Even if banks didn’t apply this level of leverage, more capital can still fuel an expansion in credit.

One concrete step that regulators can take to ensure banks maintain adequate capital is to keep a check on dividend payments, which come straight out of capital. Although it is gratifying to see most of the nation’s lenders return to profitability, the Federal Reserve erred earlier this year when it gave some of the nation’s 19 largest banks permission to resume or increase their payouts to shareholders.

We have nothing against stockholders. But until the nation’s banks have been restored to full health their interests should take a backseat to taxpayers who inevitably would be called upon in another crisis. Another method of raising capital is issuing common stock.

Banks can use this increased capital to step up lending to consumers, millions of whom own small businesses and mingle their personal and professional finances. The Fed’s latest survey of senior bank-loan officers showed that only about 10 percent of lenders have relaxed their standards for making consumer loans. And that applies mainly to customers with pristine credit records. For everyone else, it’s almost as difficult to get a loan approved as it was at the peak of the credit crunch in 2009.

This hits small businesses hard. Pepperdine University’s business school surveyed 2,595 small businesses that sought bank loans in the past year; 50 percent said they were turned down.

Outlived Usefulness

The industry’s caution is partly understandable. The financial crisis jeopardized the solvency of some of the biggest U.S. banks.

But the recession ended more than two years ago and a level of risk aversion that made sense in the turmoil of 2008 and 2009 has outlived its usefulness. Banks can afford to ease some of the benchmarks they use, such as credit scores, down payments, employment history and repayment records. Mortgages lenders, in particular, should show more flexibility for borrowers who don’t have 20 percent to put down, perhaps giving breaks to those with excellent credit records and stable job.

Bankers are sure to respond that demand for credit is low as consumers try to reduce personal debt, and businesses see little need to expand in the face of slack demand. There is some truth to this. Yet there are signs in the Fed’s survey of bank loan officers that more consumers want to borrow.

Banking is a cyclical industry. Credit tends to be too lax during booms and overly restrictive when the economy needs credit most. We would never recommend a return to the reckless lending of the bubble years. But the economy is growing again, and yesterday the government said gross domestic product rose 2.5 percent in the third quarter. Banks need to start playing catch-up.

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