Monday, October 3, 2011

The Banking Mess: It's Not Over Until It's Over

Credit inflation impacts asset values.  In a credit inflation, the expansion of credit takes place at a faster rate of growth than does the rate of increase in the production of the underlying assets.  Credit inflation can create bubbles. This occurred, as we know, in the bubble of the 1990s and the housing bubble of the 2000s.

The Federal Reserve is desperate to get credit inflation going again. This was the whole point behind the Fed’s QE2 operations.  Now, we have a version of “Operation Twist” an effort to lower longer-term interest rates relative to shorter-term interest rates.   

At present, the only bubbles the Federal Reserve has created have been in foreign assets like commodities and the stocks in emerging markets.

So far, the policy of the Federal Reserve has not been very successful in the way of domestic assets.  Credit expansion in the United States remains moribund.  And, as a consequence, asset prices seem to be remaining level.

Housing prices continue to fall, or, at best, stay relatively constant.  The stock market has gone nowhere.  Year-over-year, the Dow-Jones Average is up just 0.8 percent.  Since the same time in 2007, around the start of the recent recession, the Dow-Jones Average is still down 21.6 percent.

The only major borrowers of any consequence seem to be the largest companies and they seem to be either holding onto the cash or using the cash to repurchase their own stock.  Where once it was felt that these funds would be used for the acquisition of other companies, so far the number of acquisitions taking place have fallen below expectations as the future remains listless and uncertain.

We still have to look at the banking system for any sign of a recovery in credit and the credit inflation cycle.  And, in looking at the banking system, the signs of expansion still are absent.

A start up of bank lending is going to depend upon the status of the banks themselves…and this picture is mixed, at best.

The good news is that the FDIC is closing two of its three temporary offices.  Due to a decline in the amount of bank problems and the severity of those problems, the FDIC has decided that it can handle problem banks primarily out of its permanent offices.  The period of the ramping up of staff and the sending of staff all over the country, seven days of week, seems to be over.

Also, only 74 commercial banks have been closed this year through Friday, September 30.  In 2010 the total number of banks that failed were 157 with 30 closings coming in the fourth quarter of the year.  In 2009 a total of 140 banks failed.   Bank failures are on the wane.

Note that the number of bank failures does not include the decline in the number of banks in business.  For example, since December 31, 2007, 396 commercial banks have failed.  Yet, the number of banks in the banking system declined by 871.  This left the commercial banking system with 6,41 banks in existence. 

Likewise, about 1,000 banks and savings institutions have disappeared since the end of 2007, leaving only 7,513 FDIC insured institutions in existence on June 30, 2011.

And, still there are 865 banks on the FDIC’s list of problem banks at the end of June, down only slightly from a total of 884 at the end of March 2011.

“Camden Fine, president of the Independent Community Bankers of America, a trade group, predicted another 1,000 to 1,500 banks will vanish between now and the end of 2015.” (

My prediction has been more in the range of a further decline of 2,000 to 2,500 banks.  This will put the total number of commercial banks in the United States below 4,000.  And, I believe that the total number of FDIC insured institutions will drop below 5,000. 

The way that credit inflation works is through the rate of increase in asset prices.  In essence, if asset prices are increasing rapidly, the “real” value of the credit goes down making it much easier for the debtor to handle the increased leverage on his/her balance sheet.  This is, of course, what happened over the last fifty-year period of credit inflation. 

But, credit inflation is a cumulative process.  As people begin to borrow more, asset prices begin to rise.  And, as asset prices rise, borrowing, in real terms, becomes cheaper and so more borrowing takes place.  But, this causes asset prices to rise further, and so on and so forth.

Right now, people and businesses are not borrowing.  They are trying to reduce their debt loads because asset prices are remaining relatively constant or are declining.  The Fed is trying to get to the first stage of the cumulative process…to get people to begin borrowing again.  The commercial banks, especially the small- to medium-sized ones are not contributing to this cycle, either because the people aren’t borrowing or because the banks, because they are in trouble, are not lending. 

And, on top of this the commercial banks face two other problems.

First, the banks are facing a tougher regulatory environment that is resulting in increased costs of doing business.  Either they have to absorb the increased costs…or they have to pass them along to customers.  The debit card fees announced by Bank of America and others are just one result of this.  There is more, a lot more, coming.

Second, the banks are facing further interest margin squeezes due to the Fed’s “Operation Twist.”  Balance sheet arbitrage is dependent upon the ability of the banks to “borrow short” and “lend long.”  If these margins are narrowed because of what the Fed is doing, more pressure will be put on the banks to raise fees in order to survive.  The small- and medium-sized banks will suffer more because of this.

I believe that we need to keep a close eye on the banking system to determine whether or not the economy is going to pick up.  The banking system is still in a troubled state.  If either Camden Fine, of the Independent Community Bankers of America, or myself is correct about the continued decline in the number of banks in the United States, the commercial banking sector has a lot of adjustment to go through over the next four years or so and the focus of the industry will not be on lending. 

On the other side, the Federal Reserve is acting relentless in its efforts to start up credit inflation once again.  And, given the political climate in Washington, D. C. I don’t see any change in this attitude.

The question then becomes, when do we reach the tipping point?  When does the unwillingness of the banks to lend and the unwillingness of families and businesses to borrow lose out to the efforts of the Fed to create the credit inflation it so badly wants?  The problem is that once a tipping point is reached, the cumulative credit cycle buildup begins and I don’t really see how the Fed can prevent this from happening. However, there is no indication that another bout of credit inflation will produce more robust economic growth and job creation.   Still, keep your eye on the banks.

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