Monday, September 13, 2010

Still No Life in Banking

Over the last two months I have been hoping that the smaller banks in the United States were starting to lend a little bit again. I was even looking for “Green Shoots”. (See

My latest review of the commercial banking data released by the Federal Reserve gives little indication that things are picking up through August. Total assets at the smaller domestically chartered banks in the United States (defined as all domestically chartered commercial banks except the largest 25) grew by a little over $11 billion in the last five weeks. However, the cash assets of these banks rose by slightly more than $8 billion of this total. Only about $1 billion went into bank loans.

The total assets at the 25 largest domestically chartered commercial banks fell by about $26 billion during this time period, but the cash assets held by these banks dropped by even more. Cash assets fell by about $41 billion. What asset class rose? The securities held by these banks rose by almost $23 billion.

At these large banks, Treasury and Agency securities increased by about $210 billion over the last year. These banks can acquire funds at interest rates approaching zero percent and purchase securities with no credit risk and earn several hundred basis points spread on the transaction. And, there is little or no interest rate risk because the Federal Reserve has stated that it will keep short term interest rates extremely low for “an extended time.”

One can see this arbitrage situation setting up over the last year as these large commercial banks have changed the way they have financed their assets relying on less expensive sources of funds and substituting cheaper and cheaper liabilities.

No wonder the large commercial banks have been producing a lot of profits while at the same time building up their loan loss reserves!

Why should commercial banks lend when they have a riskless way to make money?

Business loans? Commercial and Industrial loans are down by more than 12% at all banks, from August 2009 through August 2010. At large commercial banks, however, C&I loans are down by even more, dropping at a 14%, year-over-year rate. In just the last 13 weeks, these loans are down by almost $12 billion which is about one-tenth of all the business loan portfolio in the banking system.

Commercial real estate loans are down by more than $140 billion. Of this drop more than half of the decline was registered at the smaller commercial banks. Of course, this is where people are expecting a lot more trouble over the next twelve months or so.

Surveys have indicated that banks are easing up on lending terms. Well, that may be true, but this is still not resulting in any jump in commercial bank lending.

We are told that businesses and consumers are reluctant to borrow. I believe that this is true. There are two reasons for this. First, many businesses, families, and individuals are still reducing the debt load they had built up over the last decade or more. With the economy so weak, it still represents a substantial risk to go further in debt given the uncertainty about future prospects.

In addition, many of the companies that are better off are accumulating large amounts of cash balances. The play here, I feel, is that mergers and acquisitions will pick up over the next year or so. Analysts are still shaking their heads about all the activity that took place on this front in August. My guess is that companies believe that they can achieve better market share and even have a chance to gain sustainable competitive advantages in their markets by building scale through acquisition of financially “weak” companies as opposed to attempting to expand on their own at this time. Keep the cash so that you can move as quickly as possible when the time is right.

Bottom line: it seems as if very few banks want to extend money to businesses at this time; and very few institutions (except for the federal government) want to put on a lot more debt at this time.

There will be no recovery of any strength without a pickup in commercial bank lending. I have written about this earlier: This is one reason why I am skeptical of the spending and tax-cutting proposals presented by President Obama last week. The economy is in a position where debt positions, both in the financial and non-financial industries have to be worked out and this will take time.

I continue to believe that the Federal Reserve will continue to keep short term interest rates at or near their very low current levels until the commercial banking industry stabilizes. The Fed and the FDIC are doing a good job in helping the smaller banks work through their problems. Still, there are a sizeable number of the smaller banks that are still in serious trouble and asset values are still the problem. As mentioned above, there are anticipated difficulties ahead in the commercial real estate area and some investment portfolios are still substantially under-water.

With all these difficulties, why should these smaller banks, in aggregate be expanding their loan portfolios? The main thrust in the commercial banking sector over the next twelve to eighteen months is still survival and consolidation.

My prediction still remains: over the next five years or so the largest 25 domestically chartered banks in the United States will come to control about 75% of banking assets in America, up from about 67% at the present time.

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