Thursday, July 22, 2010

The Current Performance of Commercial Banks

Commercial bank profits are OK. Commercial bank lending is practically nil.

The prognosis for the future?

If commercial bank lending does not pick up, commercial bank profits will fall.

When will commercial bank lending pick up?

Good question, but the answer is not an easy one. Also, to get an answer, it seems as if we need to go to both sides of the desk: to those that are demanding loans and to those that are supplying loans.

There seems to be four factors that are keeping loan demand from growing. First, of course, is that a lot of people and companies are still trying to climb out of the economic hole in which they have found themselves over the past three years. We still have foreclosures and bankruptcies continuing at a very rapid pace even though below record levels. We still have massive amounts of unemployment as well as underemployment. And, we still have large numbers of the American families and businesses with extremely poor credit records.

Second, there is a great amount of uncertainty about the future of business. And, confidence is not built when the Chairman of the Board of Governors of the Federal Reserve System announces before Congress…and the whole world… that the business outlook is “unusually uncertain.” If Mr. Bernanke believes this to be true, what are the people “in the trenches” expected to believe?

Third, there are a large number of companies, mostly big companies, that are sitting on a large amount of cash. These companies are not ready to commit at the present time, but they are poised to put these funds into play, either in an expansion off-shore, or in purchasing other companies. These big companies have been profitable, much like the big banks, but they are not yet ready to put these funds to a business use. As far as wanting bank loans, that will depend upon the strategies these companies want to pursue and the cheapest way to finance them.

Fourth, consumers that have the income flow or wealth continue to pay down their debt in an effort to re-balance their balance sheets. At a time like this with all the evidence around that too much financial leverage is not “the place to be”, individuals and families are not seeking credit and are even reducing the amount of credit that they do have outstanding.

From the demand side we see the reality that the people that have the income and the cash assets are not real anxious to borrow and the only ones that really want to borrow have neither the cash flow nor the cash assets to get a loan.

This gets us to the supply side. Commercial banks, in recent months, across the board, say that they have not changed their credit standards. I take them at their word. Yet, if one compares current bank lending standards with those that were in place one, two, or three years ago, the bar is set much higher than it was. This tightening of standards was to be expected as credit standards are always raised during an economic down turn. They were raised to current levels due to the severity of the 2008-2009 financial crises and to the pressures that were brought on the banks by the regulatory agencies. Although these standards will not get tougher, they will not be eased appreciably any time soon.

The commercial banks are also hit by the uncertainty of the current economic situation and by the coming imposition of new financial reform legislation. In terms of the economic situation, loan officers have to be skeptical of business projections of future cash flows. Since the economic outlook is “unusually uncertain” banks have to be extremely careful about basing the extension of money to a borrower upon “optimistic” forecasts. Even “prudent” forecasts are suspicious because of the uncertain nature of the business environment right now.

Plus, bankers, in general, and lending officers, in particular, are “debt guys”. (Please excuse the gender specificity here, “guys” refers to all bankers and lending personnel.) “Debt guys” are taught that forecasting just on cash flows is a tricky business and so it is wise, extremely wise, to require a borrower to put up collateral behind the loan. And, if cash flows projections become even more uncertain than in the past, more collateral should be required.

But, in a very uncertain economic environment, another problem rises to the surface. This problem has to do with the “value” of the collateral. In a very uncertain economic climate and uncertain secondary markets, how can you get a good estimate of what the value of “physical” capital might be? Hence, commercial banks extend their requirements for the collateral backing of loans, now requiring financial instruments, bank deposits like CDs, compensating balances, or other cash demands. Banks are getting back to the “good old days” when to qualify for a loan, a potential borrower had to prove to the bank that they did not need the loan in order for the bank to extend the money to them.

There is another uncertainty now in play. The passage of the financial regulation reform bill introduces more unknowns into the banks’ decision making. Just the concern over higher capital requirements causes the commercial banks to become more conservative in their lending practices. Furthermore, it is unclear how other rules and regulations, some of them not even written yet (the regulators have several months to write up some of the new provisions), will affect bank policies and procedures. How can commercial banks be aggressive in their lending practices it they don’t know what the “playing field” is going to look like in the future?

Finally, there are still many commercial banks that have solvency problems. As I continually quote, about one in eight commercial banks is on the list of problem banks put out by the FDIC. This list was as of March 31, 2010. Soon there will be a new list out relating to June 30, 2010. It is anticipated that the number of commercial banks on this new problem list will be greater than was the case at the earlier date.

My estimate that another two or three commercial banks out of eight still have problems pertaining to capital requirements, or, pertaining to major credit problems in the areas of consumer or commercial real estate loans. To me, this latter problem is one of the major reasons why the Federal Reserve is keeping short-term interest rates so low and will continue to do so, as Bernanke reiterated in his testimony yesterday, for “an extended period”. Market estimates for when the Federal Reserve might increase its target rate of interest now go until at least the third quarter of 2011. This says to me that there are still many, many problems in the commercial banking industry and these problems are not going to be resolved for “an extended period.”

This situation can only result in a large consolidation in the commercial banking industry in this country. Right now there are about 8,000 domestically chartered commercial banks in the United States. I remember when this number was 14,000 and this did not include an extensive Savings and Loan industry. One could see a drop by one-half or more in the number of banks in the country. And, this doesn’t even take into account the effects information technology is going to have on the banking industry in the next five to ten years.

This does not bode well for the supply of bank loans. With the changing financial regulations, the uncertain economic environment, and the changing structure of the banking industry itself, commercial banks are going to concentrate on “high quality” loans. And, if the big banks cannot find them in existing markets they will invade the local or regional markets of other banks. In fact, many banks are now talking about how the big banks are becoming more aggressive in their markets. This will not result in an increase in loan supply, but it will contribute to the consolidation in the commercial banking industry.

In short, there doesn’t seem to be much reason to expect a pickup in bank loan volume in the near future.

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