Where is Banking Headed? Not Up!

The biggest problem in the economy, I believe, is the banking system. The government recognizes this and that is why the various agencies within the government are following such bizarre policies. The Federal Reserve has kept its target interest rate below 20 basis points for over twenty months now and it appears as if it will maintain this target for at least six to twelve more months. The FDIC, as of March 31, 2010, had 775 banks on its list of problem banks and Elizabeth Warren claims that at least 3,000 banks are facing severe problems relative to commercial real estate loans. The United States Treasury Department is tip-toeing around banking issues and especially around the government agencies called Fannie Mae and Freddie Mac.

I sure would NOT want to be a bank regulator now. The workloads must be enormous and the pressure must never ease. And, in my view, this situation is not going to change for another three years or so.

For one, the industry is bifurcating. The big institutions are winning. The smaller institutions are going down the drain. One figure I am fond of quoting is that the largest 25 commercial banks in the United States control two-thirds of the assets in the industry. (This is from Federal Reserve statistics.) On March 31, 2010 there were 6,772 commercial banks in the industry (according to the FDIC) so that about 6,750 banks control only one-third of the assets in the industry.

Note this, however. On December 31, 2002 there were 7,888 commercial banks in the United States and on December 31, 1992 there were 11,463. So the number of banks in the US declined by more than 40% in the past 18 years.

But, commercial banks with more than $1.0 billion in assets increased from 380 at the 1992 date to 405 at the 2002 date to 523 this year.

Banks that had less than $100 million in assets fell dramatically during this time period: in 1992 there were 8,292 banks; in 2002 there were 4,168; and in 2010 there were 2,469.

Banks between $100 million and $1.0 billion in asset size rose from 2,791 in 1992 to 3,315 in 2002 and to 3,780 in 2010.

However, check this out. In terms of full time equivalent employees, banks with less than $100 million in assets averaged 24 employees in 1992, 20 employees in 2002, and 17 employees in 2010. The middle size of banks averaged 121 employees in 1992, 90 employees in 2002, and 72 employees in 2010.

It appears as if the part of the banking system that controls less than one-third of the banking assets in the United States has gotten smaller and smaller in terms of size of institution and employment. Yet, during the last fifty years, the people in these institutions have been asked to do more and more in terms of the environment they are working within and the pressures they feel. Banks, throughout this time period, have not been able to just live off the interest rate spread they earn between loans and deposits.

Furthermore, the thrift industry has also shrunk. The Savings and Loan industry is dead! (http://seekingalpha.com/article/214460-so-long-to-the-savings-and-loan-industry) The numbers support this demise. On December 31, 1992 there were 2,390 savings institutions in the United States. This number dropped to 1,466 at the end of 2002 and fell to 1,160 at the end of March 2010. The Office of Thrift Supervision (which was a part of the Treasury Department) is to merge into the Office of the Comptroller of the Currency (which is a bureau of the Treasury). Thrift institutions will become more and more like commercial banks and the idea of the thrift industry will fade into memory. Most of these are very small institutions, not unlike the smaller commercial banks listed above with very few employees.

I go through this list because many of the problems that now exist within the banking system are concentrated in these smaller institutions, formerly the heart-beat of Main Street America. In the last fifty years the financial environment changed substantially and a large number of these depository institutions were just not able to make the transition. We are going through the final stages of the current restructuring of the banking industry. What we will see in the next five to seven years will be difficult to compare with what existed in the last half of the twentieth century.

What changed? Well, the inflation of the 1960s and 1970s brought about higher and higher short term interest rates. For many institutions, the comfortable interest rate spreads the banks and thrifts worked with disappeared and even went negative in some instances. The government’s response was to open up the balance sheets and allow these institutions to diversify and create more services that could earn fee income. Also, new financial instruments were created to allow these depository institutions to get into more exotic types of investments.

A typical situation was one in which a depository institution had only 15 people or less with most of them being tellers or clerks and only two or possibly three that had executive authority. Most of these employees had been with the institutions for a decade or more. These institutions were flooded with investment bankers and others with all kinds of sophisticated ideas about how a $50 million organization could get into high-yielding assets or buy cheap deposits or do many other very innovative things so as to regain profitability. The late 1970s and 1980s are full of stories about how the managements of small institutions were “educated” in the ways of Wall Street. The thrift crisis resulted.

In the 1990s and 2000s even more sophisticated instruments and opportunities were brought to the smaller institutions that thought they were getting good advice to help them operate in the twenty-first century. Part of what the managements got into was commercial real estate deals. This is what Elizabeth Warren has alerted us to. But, there are many, many other institutions that have securities or other assets on their balance sheets that are not performing or are damaged in one way or another.

What is Ms. Warren talking about when it comes to the magnitude of the problem? Is she talking about a 20% write down of some assets? A 25% write down? Do these “small” banks have sufficient capital to take such a write down? Can these small banks raise sufficient new capital to cover such a write down?

Can the banking industry handle another 40% decline in the number of banks in the system? Can the banking industry absorb this contraction in the next three to five years not in 18 years? This would mean a loss of more than three thousand commercial banks and savings institutions in this time period.

This is the environment that the Fed, the FDIC, and the Treasury Department is currently working within. They have not really let us know how serious the problem is. Elizabeth Warren has perhaps given us more information than others within the government would like us to have. Maybe this straight talking is why many people are reluctant to put her in charge of a government agency. She might tell us what is really going on.

Whatever, it just looks as if the banking system has a long way to go in order to regain its health.