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 dot.com 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.” (http://professional.wsj.com/article/SB10001424052970204138204576603130578559172.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj)

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.

The Two Banking Systems in the United States

More and more it appears as if the banking system of the United States is bifurcating into two parts, the largest 25 banks and the rest. These designations, large and small, are used by the Federal Reserve System for the data they release for the whole commercial banking system.

Over the past year, the total assets of the domestically chartered commercial banking system in the United States hardly grew at all. Yet, throughout the year, the smaller banks made their balance sheets much more conservative than did the largest banks.

For one, the smaller commercial banks increased their holdings of cash assets by 10% from December 2009 to December 2010; the largest banks decreased their cash holdings by more than 21%.

Both the large banks and the smaller banks increased their securities portfolios over the year, but the smaller ones increased their securities portfolios by almost 9% while the largest banks increased theirs by only about 3%.

Over the whole year, Commercial and Industrial Loans declined across the board with the larger banks portfolio of C&I loans dropping by almost 5% while in the smaller banks, C&I loans fell by only about 3%. Real Estate loans also fell during the year dropping about 4% and 5% at the largest and the smaller institutions, respectively. Consumer loans were re-defined over the year for this Federal Reserve release so that the data year-over-year growth rates are not meaningful.

The largest declines since December 2009 came in commercial real estate loans. At the largest banks, commercial real estate loans dropped by almost 11%; at the smaller banks they fell by 8%. The troubles in the commercial real estate area show up very clearly in the banking statistics.

The conservative movement in the balance sheets of the smaller banks was continued over the last 13 weeks ending with the banking week finishing on January 5, 2011. Total banks assets fell during this time period, but not by very much. Over this time period, however, the smaller banks increased their holdings of securities by over 7% while their loan portfolios fell by more than 3%.

During this time period, loans making up the loan portfolios of the smaller banks fell across the board: C&I loans dropped by 4%; real estate loans fell by 3%; and consumer loans declined by about 4%.

The loans at the smaller banks also continued to drop through the Christmas season with C&I loans falling by over 2% in the five-week period ending January 5, 2011; real estate loans fell by just 2% during this time period; and consumer loans dropped by almost 5%.

Interestingly enough, there was a front page article in the Saturday Wall Street Journal with the title “Banks Loosen Purse Strings” which reported data from Equifax Inc. and Moody’s Analytics. (http://professional.wsj.com/article/SB10001424052748704637704576082300851916930.html?mod=WSJPRO_hps_LEFTWhatsNews) In this article the claim is made that “In the third quarter (of 2010), lenders made more than 36 million consumer loans, up 3.7% from a year earlier...That is the first year-over-year gain since the crisis began. Consumer-loan originations are expected to climb 5.9% this year, much higher than the slim 1.1% increase in 2010.” The article goes on to say that “The totals include bank-issued and retail credit cards, auto loans, consumer-finance loans, home-equity lending and student loans”. Whoops, these are not all banks are they!

But, the commercial banks do not seem to be opening their purse strings when it comes to consumer lending. Besides the drop of 5% in consumer loans at the smaller commercial banks, the Federal Reserve data also showed that consumer loans fell by 5% at the largest 25 commercial banks over the past 5 weeks.

Again, the largest declining loan class over the last 5 weeks was still the commercial real estate loan area. The decline at the largest banks in the last 5 weeks was a little under 1%, while the decline at the smaller banks in this area was over 2%.

Everywhere, the aggregate banking statistics can be interpreted as showing that the smaller commercial banks continue to “tighten up” their balance sheets. The loan portfolios of these banks experienced further declines while the banks keep building up their cash positions and the size of their securities portfolios. The largest contractions have come in commercial real estate, the area that seems to have the biggest cloud over it for the next year or two.

Generally, the largest 25 domestically chartered banks in the United States seem to be doing well.

Of course, we all heard about the 47% profit jump at J.P.Morgan Chase which was announced on Friday. This week we will get more information on how the other “large” commercial banks are doing. It is expected that the reports coming out this week will show that the bigger banks are pulling ahead.

Of interest is the areas of lending that seem to be picking up at these larger banks. For one, commercial and industrial loans are, indeed, starting to increase. Over the past 13-week period, the largest 25 banks saw their portfolios of C&I loans increase by more than 3%; these loans also showed a gain over the past 5-week period.

The one other lending area that seems to be picking up at these larger banks is the area of residential loans, mortgages. (Note: this does not include equity-line loans.) Over the last 13-week period, residential real estate loans have picked up by slightly more than 3%; these loans also registered a modest increase over the last 5-week period.

So, I still firmly believe what I wrote in my January 3, 2011 post, “Four ‘Uncomfortable Situations’ to Watch in Early 2011,” (http://seekingalpha.com/article/244531-four-uncomfortable-situations-to-watch-in-early-2011). Two of these four “uncomfortable situations” are the health of the commercial real estate area and the solvency of commercial banks that fall into the small- and medium-size category.

The small- and medium-sized banks continue to “pull-in-the-carpet.” That is, these banks continue to shrink their balance sheets and they continue to re-allocate assets to either cash or “safe” Treasury securities. They have been doing this for more than two years and show no signs of acting any differently in the near future. To me, this behavior is a real “red flag” that these institutions are not doing well.

And, these smaller banks seem to be getting commercial real estate loans off their balance sheets as fast as they can just re-confirming the problems that exist in this area.

The Federal Reserve continues to pursue the policy they call “Quantitative Easing.” Perhaps a better name for it would be “Keeping the Smaller Banks Liquid.” The reason, I have argued, for keeping the smaller banks liquid is that this allows many of these smaller banks to keep their doors open in the short run so that the Federal Deposit Insurance Corporation (FDIC) can close as many of these banks as they need to in as orderly a fashion as possible. The data continue to support this conclusion.

It's a High Frequency World

Gillian Tett raises some interesting questions in her Financial Times article today: “What can be done to slow high-frequency trading?” (http://www.ft.com/cms/s/0/d72966fa-bc2d-11df-8c02-00144feab49a.html)

She closes her piece with the most important economic question that can be asked: “To my mind, the real question which needs to be discussed—but which regulators are still ducking—is why ultra-fast trading is needed at all?”

The answer: people believe that they can make money if they have a slight edge in the speed at which they can make trades.

I don’t think that this answer is changed by going into the debate relating to the neurological research which argues that “the brain has two contradictory instincts: part of it is hard-wired to chase instant gratification; however, another part of our brain also has the ability to be ‘patient’, and delay immediate gratification for future gains.”

This is just the argument raised by the behavioral finance and economics researchers. (See my review of the book “Snap Judgment” for a discussion of this issue: http://seekingalpha.com/article/145660-book-review-snap-judgment-by-david-e-adler.) The general assumption that accompanies this train of thought is that “instinctional” behavior is irrational and therefore not productive.

To quote from Tett’s article, “in practice innovation…has a darker, impatient side too: as markets have become deeper, and more liquid, that has enabled trading to become more frenetic; similarly, as information has become more frequently available this has encouraged skittish, herd behavior.”

But, life is full of situations in which “instinct” or the ability to make quick decisions is of crucial importance. For example, we need military leaders that can make decisions “on-the-spot” as well as those that can plan out strategies for long, drawn-out battles. The military trains people over-and-over again to develop the perception and experience to make decisions in the “real time” that is necessary for winning battles and winning wars.

We can find examples in many fields where “immediate” action is needed. The education and training in these areas is intense and efforts are made to find the people that are the very best in their ability to diagnose a situation and come up with the “right decision” as often as possible.

The real difference is the capability of the person or persons making the decisions. In the military, in medicine, and in many other professions, there is a hierarchy in terms of who makes the decision. Hopefully, the people that rise to the top are those individuals that can perform well and are able to make good “snap” decisions if they are needed.

Sometimes there is licensing or other forms of identification that require test taking and hurdles to overcome in order to get the certification or advancement that will put the “right people” in the “right spot” for a specific type of “real time” decision.

In economics, these tests or hurdles are called “barriers to entry”.

In the trading of stocks and other investment vehicles, there are low barriers to entry into the industry and this includes the costs one must pay to enter an industry. As a consequence, there are many traders and not all of these have the “jet pilot” capabilities to execute trades at the speeds that are now available.

The crucial thing is that in areas where quick decisions need to be made, a premium is paid to those with the education and training, the experience, and the mental capacity to make such decisions. As I stated in the post cited above, successful decision making, over any time period, depends upon “cold analytical methodology and steely discipline, characteristics that most people, who rely too much on their instincts, don’t possess.” That is, some people are better decision makers than others, even in the very short run.

People are going to engage in an activity where they believe that they can make money. So high-frequency trading is going to take place. Individuals that cannot perform within such an environment are going to lose, and could lose a lot.

The concern of the other market participants is “what damage can these not-so-good traders do to the overall market?” As Ms. Tett states, one result of the move to high-frequency trading seems to be “more market volatility.”

The fear in this: “rising levels of speed, impatience—and short-terminism—might have actually made the (financial) system less efficient, and rational, than before” this increase in speed.

My feeling with this is that speed is something we are going to have to live with. I have argued this point before in my post “Banking at the Speed of Light”. (http://seekingalpha.com/article/208513-banking-at-the-speed-of-light) The point is that this “speed up” is happening all over the world in different kinds of decision making. It is just that high-frequency trading is getting a lot of publicity now and thus attracting a lot of debate.

In the post just mentioned, I cite the example of events happening in South Africa relating to the use of mobile phones by commercial banks to develop their customer base. In this example the discussion was around the 15 million adult South Africans that had previously been excluded from the financial system. And, the players in this effort are not small.

But, this points to another issue, the growing strength of the “new rising powers” in the world as discussed in an opinion piece in the Financial Times titled “The new disintegration of finance.” (See http://www.ft.com/cms/s/0/938e7228-bc55-11df-a42b-00144feab49a.html.) The authors, Stéphane Rottier and Nicolas Véron, are concerned about how the effort to organize and co-ordinate global financial regulation and supervision is facing issues that might reverse the trend to great co-operation. One of their concerns is that “Financial institutions from emerging countries are beginning to overtake their western peers. New financial centers are gaining market share, while emerging countries are asserting themselves in global financial rulemaking, and increasingly resist standards proposed by the member of the old north Atlantic consensus.”


This is the world of the future. This is how competition is going to progress. See “The New World Order: Smaller and Faster”, my post of August 31, 2010 (http://seekingalpha.com/article/223127-the-new-world-order-smaller-and-faster). I think most of you know how I feel about the ability of regulations to control this world. I think most of you know that I believe that many, if not most, of the big players have already moved beyond what American…and world…regulators are trying to do with respect to financial institutions and markets. Laws, regulations, and regulators must deal with processes and not “outcomes.” I have written about this many times in my posts.

Hold on, it is going to be an interesting and exciting ride!

Commercial Banking: Still Hanging On

The commercial banking system continues to contract. Loan volumes keep falling.

Total assets in domestic commercial banks in the United States fell again over the past four weeks as the banking system continues to contract. From May 5 through June 2, total assets declined by about $105 billion while Loans and Leases dropped by $48 billion over the same period of time. This is from the H.8 release of the Federal Reserve.

In the past month, Securities held by domestically chartered banks declined by over $42 billion as Treasury and Agency securities at these institutions fell by almost $22 billion and other securities fell by $20 billion.

An interesting aside is that cash assets at foreign-related financial institutions fell by over $54 billion during this four-week period. Institutions took funds from the United States and parked them back in Europe where more liquidity was needed to weather the crisis taking place there.

Splitting this up we find that the total assets of large domestically chartered banks fell by about $86 billion whereas total assets fell at smaller banks by only $19 billion.

Driving this decline was a drop in purchased funds at the larger banks with a fall of $34 billion in borrowing from banks other than those in the United States and from a decline in net deposits due to related foreign bank offices. This would seem to mirror the turmoil taking place in Europe and indicates a reduction in the reliance in funds coming from elsewhere in the world.

Other deposits at these large domestically chartered banks rose by almost $21 billion to offset some of the decline in other sources of funds.

At the smaller banks, deposits continued to run off, declining by about $11 billion while borrowings from banks in the United States also fell, declining by over $5 billion.

Commercial and Industrial Loans (business loans) held roughly constant over the past month although they dropped by about $37 billion over the last 13-week period. Real estate loans continue to drop. They declined by almost $12 billion at the larger banking institutions and fell by over $10 billion at smaller banks. The drop over the past thirteen weeks was about $30 billion.

In addition, consumer loans dropped by over $11 billion at the larger banks over the last four weeks while they stayed roughly constant at the smaller banks.

Year-over-year total assets in the banking system dropped by $256 billion, year-over-year, from May 2009 to May 2010. Loans and leases fell by $222 during the same time period.

Commercial bank lending has declined for more than a year and shows no sign of stopping!

This, of course, is the type of situation that the economist Irving Fisher was worried about when he discussed a debt deflation. Loans that are being liquidated are not being replaced by new loans, hence the decline in loan balances. This is a difficult environment for a central bank. The monetary authority may be injecting funds into the banking system but since banks aren’t lending it feels like the central bank is “pushing on a string.” ( See http://seekingalpha.com/article/209463-the-fed-pushing-on-a-string.)

The concern is whether or not the “lending problem” is a demand problem or a supply problem. That is, if the problem is a demand problem, businesses are not going to their banker to borrow money. If the problem is a supply problem, commercial banks don’t want to make loans.

My belief is that the current dilemma has been created by both sides and this is consistent with Fisher’s concern about debt deflation. In the credit inflation, everyone, banks and non-banks alike, increase their use of leverage. In Fisher’s terms, the granting of new loans exceeds the liquidation of loans so that loan balances increase. In the debt deflation period, loans are being paid down.

And, how is this showing up?

Commercial banks are holding roughly $1.2 trillion in cash assets. Non-bank companies are holding about $1.8 trillion in cash and other liquid assets. This latter number comes from the Wall Street Journal article by Justin Lahart, “U. S. Firms Build Up Record Cash Piles,” http://online.wsj.com/article/SB10001424052748704312104575298652567988246.html?KEYWORDS=justin+lahart.

From the article, “U. S. companies are holding more cash in the bank than at any point on record…” The total of $1.8 trillion is up 26% from a year earlier and is “the largest-ever increase in records going back to 1952.”

The reluctance to borrow/lend is coming from both sides of the market as both banks and non-banks attempt to re-position their balance sheets to protect against further bad times and to be prepared for when the economy really begins to pick up speed once again.

In addition, there is still the concern over the health of the smaller banks in the banking system. The largest 25 banks in the banking system make up about two-thirds of the assets of the banking system. The other 8,000 banks still seem to have plenty of problems. About one in eight of these “smaller” banks are on the problem bank list of the FDIC and between 3.5 and 4 banks have been closed every week this year. This number will probably grow over the next 12 months.

Furthermore, the Federal Reserve continues to keep its target interest rate close to zero. This has been a boon to the larger banks, but is seemingly in place to keep the situation with respect to smaller banks from deteriorating even further. Many analysts believe that the Fed will keep its target interest rate low into 2011. This reinforces my belief that the “smaller” banks in the United States are still in serious trouble. Federal Reserve officials will not confess that the low target rate of interest is to keep as many “small” banks open as possible. To do so would be disturbing to depositors and other customers of these banks.

The question is, are we really in a period of debt deflation? Certainly the loan figures discussed above could be interpreted that way. But, is this all that is going on.

The interesting thing to me is that the economy seems to be bi-furcating in several ways. For one, there are a large number of people that are under-employed and seem to be facing an extended period in which they will be living off of their accumulated wealth, if they have any, or on government welfare. Yet, there are a lot of people that are doing very, very well.

The “big” banks are doing very, very well while the “smaller” banks are scraping by, at best.

The Wall Street Journal article referred to above indicates that businesses, especially larger companies, have a lot of cash on hand and are doing better than OK. We know, however, that there are a lot of other businesses that are not doing so well and still face bankruptcy or restructuring.

One could seriously argue that when the economy really does begin to pick up there will be a tremendous shift in the structure of United States banking and industry. And, if I were to choose, I would bet on the “big” guys! Sorry, little guys!

The Special Case of Financial Institutions

In my last post, “Good Management Never Goes Out of Style”, I discussed what I believe to lie at the foundation of good management. The primary emphasis of this argument is that good management focuses upon what helped to create any competitive advantage it might have and maintains that focus over the longer run. In order to do this, good management must obtain good talent and then give the good talent the room and authority to put that talent to work. Good management facilitates good talent by creating a culture of high performance while keeping the focus of the business on what can sustain the competitive advantage of the firm.

Competitive advantage produces exceptional returns but these returns are difficult to sustain because potential competitors, seeing the exceptional returns, attempt to duplicate the results and aggressive market response reduces the firms’ advantage and drives down returns. In some instances, the firm with the competitive advantage may be able to sustain competitive advantage. However, the company may not be able to sustain the competitive advantage…in many cases, it is just not possible. In such cases the only really effective action management can take is to become very efficient and reduce expense ratios.

One recognizes when these foundational principles are being neglected when firms resort to gimmicks to achieve performance. In the last post I mentioned two such gimmicks: increased leverage and the mismatching of maturities. There are many other gimmicks that can be used such as assuming additional risk, accounting tricks (hello Enron), attempts at diversification, and secrecy. As I argued, these efforts generally represent an attempt to force results and come about either from greed or hubris or both. Because they are forced and are not related to basic underlying market realities they eventually fail, often at great cost. Arguing that the world has changed and that this world-change requires new standards only lasts for so long. Losing or changing focus may produce results in the short run but it never succeeds in the longer run.

Financial institutions represent a special case that needs to be discussed separately. The reason for this is that financial institutions are generally intermediaries and therefore depend upon the two ends of the market that they intermediate. The commercial bank is the prime example of an intermediary for historically a commercial bank took small deposits from relatively small economic units that didn’t have any alternatives to depositing it’s funds in the bank, and made large loans to larger economic units that needed the funds to run their businesses. As a consequence of the nature of the business, a commercial bank was grounded in its local or regional economy. Only a few borrowers had a national presence.

This dependency started to break up in the 1960s. Bank borrowers got larger and larger and demanded larger and larger loans. Financial markets developed so that these larger borrowers found that they had more sources of funds than before. In order to support these borrowers, commercial banks had to create new instruments to raise the funds they needed to meet the changing conditions. Commercial banks began to innovate and the result was the large negotiable Certificate of Deposit and the Eurodollar markets. These markets were large and deep, sufficiently so that commercial banks could buy or sell all the funds they wanted to at the going market interest rate. (In the terms of the economist, the supply curve of funds became perfectly elastic.) “Liability Management” was created! Now banks were only limited in their size by their capital base. And, commercial banks could become truly international!

The large customers of the banks found that their sources of funds became more elastically supplied and hence their demand for funds from their commercial banks became more elastic. Bank spreads declined!

Competition worked! Now the race was on! The rest is history!

The problem with innovation in financial markets is that finance is just about information…and the marginal cost of creating more and more information is very, very low. (For an example of this idea see “Information Markets: What Businesses Can Learn from Financial Innovation” by Wilhelm and Downing, Harvard Business School Press, 2001.) Consequently, information can be cut up in many, many different ways. The primary example of this is the Mortgage Backed Security that allows mortgages to be cut up into tranches, including toxic waste, into interest only securities, principal only securities, or any other way that might be thought of and sold.

Thus, financial innovation in making financial more efficient narrows spreads as the supplies of funds becomes more and more elastic…people can buy and sell as much as they want without affecting the price of the funds they are buying or selling. But, in such markets, leverage can become infinite! And, how do people then make money? Well, they must find mismatches…mismatches in risk, mismatches in maturities, mismatches in information, mismatches in timing. There becomes no limit to gimmicks.

We have seen two types of responses to this. First, there was an increase in secrecy. With spreads narrowing it becomes imperative that others not know what you are doing. Long Term Capital Management was noted for its attempts to keep secret what it was doing. The reason…if others know what you are doing the spreads narrow even more. (Three cheers for competition!) Another way to increase secrecy was to put things “off-balance sheet”. In this way institutions could get away with smaller capital bases and riskier business than if they kept these assets “on” the balance sheet.

The second type of response is to review your business model. This is an appropriate thing to do, but in changing ones business model one must be careful about whether or not the change really builds a different business model or not. Financial institutions responded to declining interest rate spreads by cultivating the “fee-based” business model. It can be argued that this effort really did not change the nature of the business but just shifted business. If I create the mortgage, I can then sell the mortgage for a fee. Another institution can package mortgages and get a fee for that. And, another organization can service the mortgages and get a fee for that. And, another institution can…. And, so on and so on.

In this example, the financial business has not changed…just different pieces of the package have been shifted around…and risk is located somewhere else out in the world, someplace no one knows where.

A business model can be changed in a way that can create value. This is what I think the financial services industry is going to have to do. The financial institutions industry is not the only industry that is facing massive changes in this Information Age. When it becomes nearly costless to create information, the old business loses relevance and must find a new way to create value. The question for management becomes, “What is it about what I do that I can, at least initially, create a competitive advantage?”

The follow up question becomes, “After I create the initial competitive advantage, what do I do next?” We see in the case of Information Goods that time pacing becomes extremely important. I tell the young IT entrepreneurs that I work with, “It is all fine and good that you have captured a niche in the market but you must already be planning the next generation of the product or the new, new product that you will bring to market.” Modern technology produces such an environment.

What does this mean for the management of financial institutions? That is for the future to determine. I have my own ideas. But, another question is…and this is just as important…what does this mean for the regulation of financial institutions? In building new financial regulation in this Information Age we cannot just fight the past wars…especially the wars we are now engaged in. That, of course, is the hardest thing for the Government…both the President and Congress…to do! It is going to be an interesting ride.

Can Interest Rates Resolve a Solvency Crises?

In recent weeks, we have heard a lot about something called a Solvency Crises. In this number I discuss is meant by a Solvency Crises and differentiate it from a Liquidity Crises. A central bank has to be concerned about both types of crises, but it has to be able to distinguish one from the other because the monetary authority must respond differently to each kind.

A Liquidity Crises is a short term phenomenon that arises because someone must relieve themselves of some financial assets. The recent example is that of the French bank which had to unwind a securities position that had been established by a trader working at the bank. The bank had to sell off the position in order to minimize any further losses it might have to take. The amount of the securities that were involved in the position was estimated to be around $75 billion, so we are talking about a substantial amount of securities that must be sold within a relatively short period of time.

In normal times for markets that are relatively liquid, the bid-ask spread between what people will buy a security for and what they will sell the security for is relatively narrow. That is, I can buy a security and then turn around and sell the security and will only lose a small amount of money. The narrow bid-ask spread is an indicator that the market is relatively liquid. Less liquid markets experience bid-ask spreads that are more or less wider depending upon the illiquidity of the market.

If the seller of a security has to sell a noticeably larger amount of securities within a relatively short period of time, potential buyers may reduce the ask price somewhat, but the increased discount is not unusually large. If the discount is not large, this is used as evidence of the liquidity of the market. In other words, if a sizeable amount of a security can be sold relatively quickly without much concession in price then the market is termed a liquid market. Liquid markets are, of course, very important for financial (and other) organizations because securities that trade in liquid markets can be used to adjust portfolio positions under normal circumstances with little or no penalty in terms of price concessions to the market.

However, if a large amount of securities must be sold within a very short period of time, even liquid markets can experience liquidity problems. This is what is termed a liquidity crisis. What happens in these cases is that market participants know that the securities must be sold and they know that a large amount of the securities must be sold. Very often market participants will even know which institution has to sell the securities. Under such circumstances the problem becomes one of price.

In a normal situation when a larger block of securities is sold, potential buyers know that this sale is just a ‘bump’ in the market and that the market will return very quickly to the range that this type of security had been trading within. Thus, market participants know where the market is and they are willing to continue to ‘make a market’ in the security.

In a liquidity crisis this is not the case. Market participants know that price concessions must be made but because of the quantity of the securities that must be sold on the market and the short time span over which they must be sold, confidence wanes as to where the market will continue to trade. Buyers become unsure…sellers become desperate! The problem, therefore, switches to the buy side. Buyers don’t want to buy a security, even if the seller is willing to give up a substantial discount, if there is a concern that they, the buyer, will soon be holding a security for which they overpaid. Buyers withdraw…they head for the sidelines…they go and play golf. And, buyers will stay on the sidelines until the markets exhibit some kind of stability and they can become confident about where prices should be.

The job of stabilizing the market in a liquidity crisis is that of the central bank. There are two actions that the central bank can take that are the classical responses of central banks to such a market situation. Putting these responses within the structure of the Federal Reserve System we call them the lender of first resort response and the lender of last resort response. In terms of the former, the Federal Reserve reduces the operating target for the Federal Funds rate, which, in essence means, that the Fed will become a buyer of securities at a set price so that the market knows there will be a buyer for their securities…hence, institutions that need to adjust their portfolios know that they can sell to the Federal Reserve. The latter response has to do with the Borrowing window at the Federal Reserve. In the case of a liquidity crisis, the Fed, for a short time, will throw open the borrowing window so that banks can borrow funds from the Fed and not have to sell securities into a declining market. In both cases, the Federal Reserve, in classical central banking style, provides liquidity to the money markets in order to stabilize markets and keep buyers at their trading desks. This is how a liquidity crisis can be stemmed.

It is time to get back to the problem of the solvency crisis. The problem of solvency occurs when there is a decline in the value of assets that are being carried on the balance sheet of an organization. Solvency can be an issue within the context of a liquidity crisis when the securities on, say, a bank’s balance sheet lose market value. However, the problem becomes of much greater concern if the institution, the bank, experiences a decline in the value of other assets on its balance sheet, say in its loan portfolio. Here the difficulty may be the ability of the borrower to repay the loan that they have outstanding with the bank. In these cases, the bank knows that it will not receive back the total amount of the loan outstanding and, therefore, must write down the value of the loan.

The concern here is that when asset values on a balance sheet are written down the impact ultimately impacts the capital position of the organization. When we write off a loan, for example, we write it off against income reducing profits, which means that the increase in net worth will be less than it otherwise would be, or, it the charge-offs result in a loss, net worth would actually decline. If the capital position of the bank gets too low, then the bank will have to raise more capital, sell itself to another financial institution, or close. When many banks have this kind of problem there is a solvency crisis!

Raising capital is the only long term way to resolve a solvency problem and there are basically two ways to raise capital. First, over time, profits will increase the level of capital that an organization will have. This takes time and is the solution to the crisis only if institutions have sufficient remaining capital to replenish capital by means of longer run profitability. Second, the institution must go out and obtain capital from other sources. The availability of capital is dependent upon two things…that there are pools of capital available for investing…and that the institution has sufficient viability to justify investors risking their funds by investing in that institution. The Sovereign Wealth Funds have provided the pools of capital required to meet at least some of the needs of the current solvency crisis. One presumes that these Funds have done their due diligence and hence believe that their investments have long term viability.

The Federal Reserve cannot resolve a Solvency Crisis. That is, a central bank is not in a position to inject capital into banks or other organizations in order to resolve this kind of crisis. If there are not pools of funds available to put capital into troubled institutions then the solvency crisis can cumulate and spin out-of-control like it did in the Great Depression of the 1930s. The only thing the central bank can do is to help create a favorable environment so that the economy can grow and sufficient profits can be generated to replenish capital in this way. But, this takes time and patience…it cannot be done quickly.

It has been argued that Ben Bernanke and the Fed failed to realize the severity of the economic problem soon enough and did not act quick enough to lessen its impact. In my next post I am going to look at the operational behavior of the Fed in 2007 in an attempt to discern whether market conditions existed during 2007 indicating the existence of a liquidity crisis. If a liquidity crisis did not take place in 2007, then this may explain why the Fed did not want to take any precipitous action during that time when the extent of the problem was not obvious…particularly when there were other issues on the table like the decline in the value of the US dollar and the inflation being slightly above the range acceptable to the policymakers.