Big Banks Get Bigger While the Smaller Banks Disappear

The FDIC released data on the state of the banking industry last week.  And, we see that the size and number of the bigger banks increase while the size and number of the smaller banks continue to decline.

Let’s look at the number of banks in the United States first.  The number of banks in the United States dropped by 61 from June 30 to November 30 leaving only 6,352 banks still in existence.  Note that the FDIC closed only 26 banks in the third quarter of 2011.

Over the past 12 months, the number of banks in the banking system dropped by 271 banks. 

Obviously, if we focus on just the number of banks that the FDIC closed, we are not getting the whole picture as many unhealthy banks that might eventually be closed are being acquired.

The number of banks on the FDIC’s list of problem banks dropped to 844 on September 30, down from 865 on June 30.  So, the number of banks on the problem list dropped by 21, the number of failed banks was 26, and the number of banks leaving the banking system was 61.  Seems like more banks went on the problem list than left it in the third quarter of the year.  Maybe the statistics on problem banks is not as "jolly" as indicated. 

Over the past 12 months, however, the largest bank classification, banks with assets in excess of one billion dollars rose by 10.  Banks with less that $100 million in assets declined by 176 over the past year and banks with assets between $100 million and $1.0 billion dropped by 105.

Whereas the average size of banks in these last two categories remained about the same over the past year, the average size of banks over $1.0 billion in rose by $1.5 billion to $22.0 billion.

At the end of September 2011, there were 2,208 banks that were less than $100 million in asset size and these banks represented about 1.0 percent of the assets in the banking industry.  On the same date, there were 3,626 banks with assets ranging from $100 million to 1.0 billion, and all of these banks just controlled slightly more than 8.0 percent of the assets in the banking industry.

There were 518 banks in the United States that had assets in excess of $1.0 billion, and these 518 banks controlled 91.0 percent of the assets in the banking industry.

In terms of loans, Net Loans and Leases at the smaller commercial banks declined by almost $8.0 million over the past year, by $2.5 million over the past quarter.  The Net Loans and Leases at the middle range of banks dropped by a little less that $50.0 million over the past year and by about $4.0 million over the past quarter.

In the larger banks, Net Loans and Leases increased by more than $70.0 million over the past year and by about $36 million over the past quarter. 

The bottom line is that commercial banks with assets totaling less than $1.0 billion continue to produce statistics that cause one to question the health of this segment of the banking industry.  In addition, given the decline in total assets in these banks, the sector has not observed a consistent reduction in noncurrent assets (past due loans).  That is, there has only been a modest reduction in the average amount of noncurrent assets to total assets over this time period. 

Consequently, the larger banks are getting larger and becoming more dominant all the time.  And, if one looks at Federal Reserve statistics, the largest 25 domestically chartered banks in the country control about two-thirds of all the assets held by domestically chartered banks.  Thus, if the largest 518 banks in the country control 91.0 percent of the banking assets, this means that 493 banks that are larger than $1.0 billion in asset size but are not among the 25 largest, control about 24 percent of the assets. 

All the statistics show that the small- to medium-sized banks are really becoming insignificant in the United States banking industry and, given the troubles that many of these banks still face, will become even less significant in the future. 

An article in the Monday edition of the Wall Street Journal presents research showing that the health of the banking industry is being questioned by the stock markets.  Andrew Atkeson and William Simon write that “The recent volatility in bank stocks is a signal that U. S. banks, large and small, are not as healthy as many analysts assume.” (http://professional.wsj.com/article/SB10001424052970204531404577052493270860130.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj)

“The dynamic has played out twice before over the past 85 years—in the Great Depression and the panic of 2008-09—with devastating consequences for the broader economy.  Over the past three months, investor uncertainty about the soundness of bank balance sheets, manifested in the daily volatility of stock prices is back up to levels seen historically only in advance of these two great crises.”

“This extraordinary volatility is not limited to the stocks of large banks but extend to small and midsize banks as well.”

So much has been written about the condition of the banking industry in Europe.  Very little has really been written about the condition of the banking industry in the United States.  Investors in the stock market seem to have picked up this concern.

And, I have argued for more than two years now that the major reason that the Federal Reserve has pumped so much money into the banking system is that the United States banking industry has severe problems.  And, the fact that banks have held onto these funds as excess reserves and have not loaned them out is an indication of the fact that many of the banks are still not solvent.  However, the fact that the Fed has provided so many excess reserves to the banking system has allowed the FDIC to either close banks or approve acquisitions of weak banks as smoothly as possible.  The Fed and the FDIC have, so far, prevented any panic from occurring. 

However, problems remain. 

Restructuring Big Banks

The “new” trend amongst the big banks is to cut jobs.

The “big” HSBC has announced that it will be cutting 10,000 jobs in the near future, part of what many analysts expect to be part of a 30,000 reduction in jobs that will occur over time. 

This joins the efforts of other major banking organizations to scale down such at the Swiss banks Credit Suisse which announced earlier that it was eliminating 2,000 positions and UBS which said it was eliminating at lest 5,000 jobs.

In the UK, Lloyds Banking Group stated in June that it was cutting about 15,000 jobs which follows the news that the Royal Bank of Scotland has already dropped 28,000 positions with more to come in the near future.  Goldman Sachs is also cutting staff, as is Barclays Bank. 

Then, of course, there are the European banks in Ireland, Spain, Greece, and elsewhere that are facing massive amounts of restructuring. 

The big banks have had a fifty-year ride becoming over time huge global empires.  They have gone into this business and they have gone into that business without taking a breath in the process.  As “Chuck” Prince, former Chairman of Citigroup said…the music kept playing, so that the dancers had to keep dancing.

Which led to the situation that I discussed in my last post,  “Can Anyone Manage the ‘Too Big To Fail’ Banks?” (http://maseportfolio.blogspot.com/). 

A problem associated with this situation is whether of not these “Too Big To Fail” banks can be regulated.  There is, of course, some belief that these banks cannot really be controlled, especially with the advances that are taking place in the world of information technology. (See my “The Future of Banking: Dodd-Frank at One Year”, http://seekingalpha.com/article/281090-the-future-of-banking-dodd-frank-at-one-year.)

The question I asked in the first post mentioned was whether or not their shareholders could significantly influence these large commercial banks so that some control could be established over bank managements to reign in “undisciplined” growth and risk taking.  That is, could market performance become a sufficient reason for shareholder governance in the case of these financial institutions that were deemed “Too Big To Fail”? 

The basic reason given for the reduction in jobs given by the banks mentioned above was that revenue growth had deteriorated and cost cutting was needed to bring return the banks to greater profitability.  

Banks profits rebounded after the financial crisis, first, because of trading profits earned in volatile financial markets, and, second, due to reductions in provisions for loan losses. 

However, the banks have not been able to continue producing higher profits due to these factors and with lending, even at the larger banks, so anemic, managements have had to look elsewhere to beef up margins. 

In my mind, this effort at cost cutting does not answer the fundamental question about the future of the large commercial banks. 

Cost cutting is one, immediate management response that can improve profit margins.  The fundamental question to me is whether or not this cost-cutting is connected in any way with a management effort to restructure an organization so as to make sense establish the economic rationale of the bank and to be able to better manage the risk profile of the bank. 

The concern here is that the cost cutting is tactical and not strategic. 

These large financial institutions have grown almost without limit for fifty years and have added businesses more often than not just to increase the size of the organization and have added risk to their business structure without sufficient knowledge or control of what was being assumed.  Furthermore, many organizations used accounting “gimmicks”, financial leverage, and inadequate risk-taking oversight to achieve reported performance goals, which hid basic structural weaknesses.

The fundamental question has to do with whether or not bank managements are to be held accountable for their poor performances.  Will the focus of bank management’s change? 

Many times a change in the focus of bank management will only occur if there is new leadership of the management team.  In the case of HSBC, Lloyds, and Barclays, there has been a change in the past year.  These “new” leaders are expected to shift the direction of their organizations.  Citigroup and Bank of America have had new leaders in the past two years or so.  Citi has seemingly undergone a significant change in direction although better performance is still in the future.  Bank of America seems to be going nowhere, fast.

HSBC also announced another move that seems more “strategic” in nature.  It has agreed to sell 195 branches in upstate New York to First Niagara bank.  This effort, along with the closing of branches in Connecticut and New Jersey, is part of an attempt to rationalize its branch network, worldwide.  HSBC is also seeking to sell its credit card business.    Other areas of the bank are under scrutiny.

Of course, these moves are only “strategic” if they are more than just the “fad” of the moment.  And, this is the ultimate question.  Cost cutting can be a fad.  Other organizations are doing it so I cannot be criticized for cost cutting since others are doing it. 

This “strategy” can be extended to other efforts that only last until “things start to pick up again.”  That is, this “strategy” will only continue until the music starts to play again and everyone must get out, once again, on the dance floor.

Thus, one can still ask, “Can anyone manage the ‘Too Big To Fail’ banks?”

My view is that it is too early to tell. 

Right now the incentive is to re-trench and re-structure.  However, in man circles, especially in the United States, there is still a lot of pressure for governments to inflate credit.  (Need one mention Paul Krugman of the New York Times, “The President Surrenders”, http://www.nytimes.com/2011/08/01/opinion/the-president-surrenders-on-debt-ceiling.html?_r=1&hp.) 

If credit inflation remains the policy of choice of the United States…and others…and continues to dominate the economic scene then I believe that the “fad” will end and the financial institutions will start to dance again.            

If debt deflation dominates, then I truly believe that we will see better management in the financial sector and financial conglomerates will become more rational and risk-taking will be better controlled.  As I have written elsewhere, this is the other side of the process where government provides too much stimulus for an extended period of time, people and businesses respond accordingly, and then, since this situation becomes unsustainable, people and businesses must adjust back to a position that is more sound, economically, and therefore more sustainable. 

Federal Reserve Continues to Underwrite Big Companies and Big Banks

Economic spokesperson for the Obama administration, Ben Bernanke, and the Federal Reserve System continue to underwrite “big”…Big Companies and Big Banks.

The Federal Reserve has just released its survey of senior credit officers. The headlines, “Large United States Banks are Starting to Ease Credit Terms.”

Terrific!

“Large companies may also be finding an appetite to borrow, especially for mergers and acquisitions…The start of January was marked by a record level of M&A and 77 per cent of banks that reported an increase in loan demand said deal financing was a somewhat to very important reason for it.” (See http://www.ft.com/cms/s/0/6dbf2546-2d71-11e0-8f53-00144feab49a.html#axzz1Chh2pOYC.)

But wait…”A flood of cash by investors seeking to profit from rising interest rates is having an unintended effect in the deal world, where this money is being recycled into corporate buyouts.

Investors have been selling bonds which typically lose money when interest rates rise and putting their cash in funds that invest in bank loans that finance corporate buyouts. The loans have floating rates, so the interest they pay investors rises as rates go up.” (http://professional.wsj.com/article/SB10001424052748704254304576116542382205656.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

Wow! Have I got a deal here!

And, what about big banks? Well, Bloomberg has an answer for that: “Fed’s Easy Money Helps European Banks Refinance.” (See http://www.bloomberg.com/news/2011-02-01/fed-s-easy-money-helps-european-banks-refinance.html.)

Seems as if European banks are selling record amounts of dollar-denominated bonds to refinance almost $1 trillion of their debt maturing this year. “As a result of the extra dollars created (by the Fed’s quantitative easing), cross-currency basis swaps show that it’s cheaper for European banks to sell bonds in dollars and swap the proceeds back to euros than it was at the same time last year.”

European lenders “sold $43.8 billion in investment-grade bonds in the U. S. (this January), beating the previous record of $42.4 billion last January.”

So the Federal Reserve’s quantitative easing is doing good!

Yes, but what about economic recovery and the smaller banks and smaller businesses?

The Financial Times article continues: “If most of the increased loan demand is for M&A, it may be slow to feed through into higher investment in the economy.

The scope of easier credit also remains limited: Large banks say they are lending more to large companies, but life has become no easier for small companies and small banks.

There was also little sign of any improvement in lending for either commercial or residential real estate.”

It is in the smaller banks and the smaller businesses that solvency concerns still reign. It is in
commercial and residential real estate that economic conditions remain depressed and credit woes abound.

Big banks and big corporations have lots and lots of cash. The reason for this build up in my mind has been for the “Great Acquisition Binge” of the 2010s. (See my post “Where the Real Deals will be in 2011: http://seekingalpha.com/article/244709-where-the-real-deals-will-be-in-2011.) And the bank lending reported above is just adding to the acquisition cycle. The big banks are now increasing lending and, it looks as if the increased lending is going for more and more buyouts. The hedge funds and private equity funds are now stepping up their involvement in this exercise as is evidenced by the interest in floating rate loans.

And, how is this banking activity helping to get the economy growing more rapidly and reduce unemployment?

If anything, the increased merger and acquisition activity will result in a “rationalization” of business which will mean that the acquiring firms will engage in more downsizing of the acquired firms and this will mean that more workers will be laid off.

Companies will become bigger…there will just be fewer companies around.

If this is the case, why does the Federal Reserve continue to underwrite the big banks and the big corporations?

I continue to argue that the Federal Reserve is pursuing quantitative easing as aggressively as it is doing in order to keep the smaller banks going as long as possible so that the FDIC can close as many as they need to in an orderly fashion. Eleven banks have already been closed this year.

Last year the FDIC formally closed a little more than 3 banks per week throughout the year. However, the number of banks in the banking system dropped by two to three hundred (we don’t have the final numbers on this yet) when you count the mergers and acquisitions that took place in the banking industry.

My guess is that we will experience the same amount of contraction of the banking system in 2011. The monetary stance of the Federal Reserve is crucial for the banking system to continue to contract in an orderly fashion. But, this is not necessarily spurring on economic growth.

Until this contraction is over, the feast will continue for the biggest banks and the biggest corporations.

Banking is Changing: Look Out for the Opportunities

Banking is changing. I have argued this case for a long time. The number of banks in the banking industry is declining. A year ago or so we had over 8,000 commercial banks in the banking industry and several thousand organizations called thrift institutions. Now, we have less than 7,800 in the banking system and the thrift industry is legacy. My guess is that over the next five years, the number of commercial banks will drop below 4,000. This, of course, does not consider the credit unions and the increasing role they play in financial services.

The largest 25 commercial banks in the banking system hold about two-thirds of the assets of domestically chartered banks in the banking system. These banks hold over 57% of all the banking assets in the United States. Foreign-related financial institutions hold almost 13% of all banking assets in the United States. Thus, the biggest 25 domestically chartered banks in the United States banking system plus foreign-related financial institutions in the United States hold 70% of all banking assets.

This means that the average size of commercial banks not included in the largest 25 banks is a little more than $450 million. This means that there are a lot of very, very small banks “out there.”

What if the 25 largest banks in the United States plus foreign-related financial institutions move up to 80% of the total banking assets in the United States which I believe will happen? If the banking system drops to below 4,000 banks and, just to build an estimate, the asset size of the banking system doesn’t grow, then the smaller banks in the banking system will average right around $600 million.

The only conclusion that one can draw from the assumptions I am working with is that the big banks are going to get bigger, foreign banks are going to play a larger role in the United States banking industry (See “Japan’ No. 1 Bank on Prowl,” http://professional.wsj.com/article/SB10001424052748704881304576093630151255362.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj), and the smaller banks are going to get bigger.
Given this scenario the question becomes “How are commercial banks going to change?”

I would like to call your attention to a book I reviewed back in August by Leo Tilman, “Financial Darwinism,” (http://seekingalpha.com/article/221607-making-money-in-the-21st-century-financial-darwinism-create-value-or-self-destruct-in-a-world-of-risk-by-leo-tilman). The book is subtitled “Create Value or Self-Destruct in a World of Risk.”

One distinction Tilman makes in his book is between the “static” model of financial management and the “dynamic” model that incorporates a totally different risk-management perspective.

The general “mode of operation” of institutions existing within a “static” framework is akin to the “carry trade.” Simply, the “carry trade” can be defined living off the differential returns between assets and liabilities. Because of the “local monopolies” that commercial banks historically operated in that were controlled and regulated by the banking authorities, commercial banks could engage in “balance sheet arbitrage” and earn a very good living. (Lend at 6%, borrow at 2%, and be on the golf course by 4:00.)

As the local monopolies broke up in the 1970s and 1980s and the Net Interest Margins of banks began to decline, commercial banks started concentrating on fee income to keep returns up. But, this only worked for so long. As a consequence, Tilman argues, financial institutions, particularly the larger ones, began moving into “Principal Investments” and “Systematic Risks.”

Principal Investments (primarily “alpha” type of investments) include private equity funds and venture capital investments, proprietary trading, hedge fund activity and other forms of investment in financial instruments, products, and tools. Decisions were generally made at executive levels, but were decentralized with risk only being considered within a specific silo.

Examples of Systematic Risks (“Beta” type of investments) include operating in markets where the organization were exposed to interest rate risk, credit risk, mortgage prepayment risk, commodity risk, currency risk and so forth. Again, these efforts tended to be compartmentalized.

Even for the bigger institutions these latter movements were not aggregated and integrated: risk management in these financial institutions remained “static” even though the world became “dynamic.”

For the smaller commercial banks that moved in this latter direction, they tended not to know what they were doing. In doing bank turnarounds, it always amazed me the number of managements that felt they could deal with the most sophisticated financial instruments available, yet couldn’t manage their own “balance sheet arbitrage.” Moving into areas that were not based on “traditional” banking models only exposed these smaller banks to disaster as markets collapsed and they descended into insolvency.

The bigger banks have learned a very costly lesson relative to risk management. This is what Tilman’s book is all about. Within the dynamic world of modern finance, commercial banks are not going to be able to live off of “balance sheet arbitrage” alone. More and more these bigger banks are going to build portfolios of “Principal Investments” and investments with “Systematic Risks.” But, they are going to integrate and manage their risks differently. And, the management of these risks are going to be world-wide as the United States banks take on more of a global presence and as foreign-related financial institutions become more prominent in the United States. (http://seekingalpha.com/article/247734-u-s-financial-regulations-are-making-the-institutions-and-markets-irrelevant)

One major differentiator of performance in large banks is going to be tied to the ability of top management to manage the risk of their multi-structured institutions. This is one of the reasons why Jamie Dimon and JPMorgan, Chase & Company supposedly got through the recent financial collapse as well as they did. (http://seekingalpha.com/article/148179-book-review-the-house-of-dimon-by-patricia-crisafulli)

Smaller banks, however, are not going to be able to operate in these areas requiring a sophisticated understanding of how these risks are managed but also require a very sophistication management team to manage them. The smaller banks are going to have to find out how they can become better at “balance sheet arbitrage” and build up an expertise in these areas so as to “out-execute” rivals. This will be their way to “raise the bar.”

The other major differentiator will be the control of expenses: this will have to do with the structure of the branching system and number of bank personnel. It is embarrassing to walk into sizeable bank branches these days and see five employees of the bank and maybe two or three customers. I don’t remember walking into a bank recently where this was not the case.
Furthermore, commercial banks are way over-staffed in their back offices. Managements have not really dealt with this issue in recent years because they have either been “dancing to the music” or had major solvency proglems to deal with. But, now attention is starting to be paid to the excessively high expense ratios that exist within banking. (http://professional.wsj.com/article/SB10001424052748703921504576094431636101722.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

One way the banks are going to change in this area is in their use of information technology. (http://seekingalpha.com/article/225773-the-new-world-order-smaller-and-faster-part-2) I plan to spend more time on this in the future and will also be spending more time discussing banks that are changing.

Commercial Banking in 2011

Commercial banking in the United States is going to change substantially in the next five years.

Most of my comments on the banking industry over the past year have been spent on the “smaller” banks, the banks are not among the 25 largest commercial banks in the industry, the banks that control about 30% of the banking assets in America. At last count there were a little less than 7,800 of these banks. The average size of the banks in this category is about $480 million, pretty small.

My concern about these banks is their solvency. The FDIC placed 860 commercial banks on its list of problem banks at the end of the third quarter. The question that is still outstanding is how many more banks are seriously challenged to remain in business. That is, how many banks are not on the problem list but “near” to being on the problem list. Elizabeth Warren gave testimony in front of Congress in the spring and stated that 3,000 commercial banks were threatened by bad loans over the next 18 months.

Commercial banks have been closed at the rate of approximately 3.5 per week during 2010 and many other acquisitions have taken place. So, the industry is shrinking. I still believe that there will be fewer than 4,000 commercial banks in the United States by the end of the upcoming decade.

However, something new is going to happen at the other end of the banking spectrum. International banks are going to play a much bigger role in the United States in the future and this is going to substantially change the playing field and will help to accelerate the decline in the number of banks in the American banking system.

What’s going on? Just in the recent past we have had the news that the Bank of Montreal, the fourth largest bank in Canada, acquired the banking firm of Marshall and Ilsley Corp., which has $38 billion in deposits, 374 branches throughout the Midwest, and is the largest lender in Wisconsin. Then we learned that TD Bank, the second largest bank in Canada, is acquiring Chrysler Financial, the former lending wing of the Chrysler Corporation.

We also learn that Deutsche Bank AG and Barclays PLC have moved up the rankings of global business when compared to other Wall Street organizations. (See the Wall Street Journal article “New Banks Climb Wall Street Ranks,” http://professional.wsj.com/article/SB10001424052748703581204576033514054189044.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj.) These organizations have grown substantially filling in some of the hole left by the collapse of Lehman Brothers, and the moving of Bear Stearns and Merrill Lynch into other banking firms.

The point is that the American banking scene is much more open to foreign competition on its own turf in the 2010s than it was previously. This has the potential for causing even more changes in the structure of banking in the United States and in the world than we have seen over the last fifty years.

If we go back to the start of the 1960s, the United States contained some 14,000 commercial banks and a large, prosperous thrift industry. But, things were changing. Let me point out just three of the major factors impacting the banking and thrift industries by the start of the 1970s. First, was the beginning of the credit inflation that was to spread throughout the economic system that would result in the rising interest rates which would eventually bankrupt the thrift industry and drive it out of business.

Second, the United States commercial banking system at the start of the 1960s was a mish-mash of banking rules. For one, the branching laws were such that banks could not branch across state lines, and in some states banks could only have one office, in others they faced severe limits on the number of branches they could have, while in other states there was unlimited state-wide branching.

What broke this structure down? Information technology. With the spread of information technology banks could not be constrained from branching across state lines. The death knell for state control and limited branching was sounded. National competition became the new norm and banks had to compete.

The third factor was the freeing up of the flow of funds internationally. By the end of the 1960s the capital flows were basically unrestricted between the United States and Europe. One of the major signs of this openness was the creation of the Eurodollar deposit which became an important tool in the move to “liability management” which freed up American commercial banks from limits on their ability to grow their balance sheets. This factor contributed to the demise of the “Bretton Woods” system of international finance.

All three of these factors played a big role in the changes in the financial system of the United States and the world and to the movement away from “relationship finance” and “arms-length finance”. For more on the changes in the banking system and the growing “impersonal” nature of the financial system see the book “Saving Capitalism from the Capitalists” by Raghuram Rajan (the winner of the Financial Times/Goldman Sachs award for the best business book of the year, “Fault Lines”: http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan) and Luigi Zingales, both of the University of Chicago.

All of these factors are still at work but we are now seeing another important factor coming into play, “competition from the outside.” Just as the forces inside the United States have been attempting to build up walls to constrain the finance industry, America is now coming to experience a breaking down of the barriers. Unless the Congress puts up restrictions on foreign financial interests acquiring domestic companies, it seems as if the door is opening for more and more banks from outside the United States to come knocking.

The result of this “opening up” according to Rajan and Zingales is that the new competition really “shakes things up.” I have contended throughout the events which began in late 2008 that by the middle of 2009 the largest 25 commercial banks in the United States had moved beyond most of the structural problems that contributed to the financial collapse. Furthermore, by the time that the Dodd-Frank Financial Reform bill got passed, these banks had moved beyond most of the onerous portions of the legislation.

Now with these foreign financial organizations moving into the competitive space of the United States banks, all banks will be using information technology and uncontrolled capital flows throughout most of the world to further outpace efforts of regulatory reform.

Another consequence of this will be the pressure on the larger banks to continue to merge and acquire and diversify their businesses in ways we have not yet imagined. And, when one brings into the picture the things that information technology can do and the progress the “Quants” have made in finance, one can only guess at how exciting the near-term evolution of the banking system is going to be.

Merry Christmas and Happy New Year to Everyone!

The Banking System Seems to be Dividing: Large Versus Small

The last three months have seen more and more weakness in the smaller commercial banks in the United States. Last month I ask the question, “Is A Crunch Coming for the Smaller Banks?” (http://seekingalpha.com/article/229385-is-a-crunch-coming-for-smaller-banks)

This month things continued to decline amongst the smaller banks while the largest 25 banks in the country really seemed to expand.

Over the past four weeks ending Wednesday October 27, the biggest 25 banks in the country saw their assets increase by almost $94 billion while the assets at the smaller banks rose by only about $8 billion; but the cash assets at the smaller banks rose by almost $19 billion.

Over the past quarter, the total assets at the larger domestically chartered banks increased by a little less than $20 billion while the assets at the smaller banks actually declined by about $9 billion. Cash assets at the smaller commercial banks rose by over $33 billion during this time.

Loans and leases at the smaller commercial banks have fallen by $14 billion over the last four weeks and by almost $32 billion over the last 13-week period. And, where has most of this decline come from? Commercial real estate loans!

This is, of course, is where many analysts, including Elizabeth Warren, have predicted the trouble would come from until the end of 2011 or so. Warren even stated in congressional testimony that there were some 3,000 commercial banks that were going to face severe problems in the commercial real estate area as these loans either matured and had to be re-financed or went into a delinquent status.

Over the past four-week period, commercial real estate loans at the smaller banks fell by almost $10 billion. Over the past 13-week period, these loans dropped by over $23 billion.

Looking back over the past year ending in September, commercial real estate loans at the smaller commercial banks declined by $74 billion, with half of the decline coming in the last six months.

The decline in assets at the smaller commercial banks is coming exactly where Warren and others warned they would come. But these banks also moved more and more into cash assets during this time indicating a very risk averse position. Over the past thirteen weeks the smaller banks did exactly the opposite of what their larger competitors did: the smaller banks added $33 billion to their cash asset portfolios while the bigger institutions reduced their cash by $30 billion.

The largest 25 banks are still not aggressively pursuing loans. But, their securities portfolios continue to increase. Over the last four weeks, securities held by the largest banks in the country increased by almost $32 billion while they rose by almost $60 billion over the past 13-week period.

This behavior is also exhibited over the last twelve months, ending in September 2010. During this period, large commercial banks increased their securities portfolio by almost $125 billion while their portfolio of Commercial and Industrial loans fell by almost $80 billion and their portfolio of real estate loans dropped by $41 billion.

Some of the financing of these securities came from the cash assets of these large banks which declined by almost $70 billion during this time period. The largest supplier of new funds to these institutions came from something called “Borrowings from Others”. In essence, the larger banks seem to be playing an arbitrage game. They are borrowing short and buying long term securities. The risk to them seems minimal since the Federal Reserve is keeping short term interest rates exceedingly low for “an extended time.” An “extended time” seems to go well into next year.

The largest commercial banks are going to do just fine. They will continue to get stronger and bigger in the future.

The smaller banks continue to struggle. The problem here is that we, the public, really don’t have a handle on how serious the situation is with respect to the solvency of the smaller commercial banks in the banking system.

The “surprise” sale of Wilmington Trust last week took most people by surprise, even the very astute analysts. (See http://seekingalpha.com/article/234027-wilmington-trust-sold-at-45-discount.) Here is a bank known for its conservatism and, in addition, it was solidly producing earnings through its trust department. Yet, the bank had failed to really report the truth about its loan portfolio. Here is a bank, roughly around $10 billion in asset size with bad assets totaling around one billion dollars. How could this happen without someone knowing about it?

How many more commercial banks like Wilmington Trust are out there?

Bankers…lenders…do not like to admit that they have bad loans. In general, they postpone reporting bad loans until it is too late for them…and their shareholders.

Elizabeth Warren said that there were about 3,000 commercial banks in the banking system that were going to face serious strains over their commercial real estate loan portfolio and their construction loan portfolio.

Recent data indicate that large dollar amounts of commercial real estate loans are leaving the balance sheets of the smaller commercial banks in the United States. It would appear as if more and more of these bad assets are being recognized and removed from the banks’ balance sheets.

More and more people are calling for commercial banks to recognize their bad assets so that the United States can start to grow again. I believe that more and more people are realizing that a strong economic recovery is not possible until something is done about these bad assets…until they are written off the balance sheets of the commercial banks.

One of the problems that the Obama team is really going to have to deal with soon is to appoint some people to provide economic and regulatory advice and administration. On the economic side, only Tim Geithner at Treasury and Austan Goolesbee at the President’s Council of Economic Advisors are in place. On the regulatory side connected to depository institutions, only “Bubble” Ben will be in place by the middle of next year. The Office of the Comptroller of the Currency has an acting head. I was at a banking conference last week and there was talk that Sheila Bair, Chair of the FDIC is expected to leave next year and does not want to be re-appointed. The Office of Thrift Supervision is merging into the OCC and the top people are looking elsewhere for leadership. Many leadership positions are empty.

One could almost say there is little or no leadership at the top in Washington, D. C. when it comes to economics and banking.

And yet, 2011 could be a crucial year in American history for determining the future of the structure of the financial system.

Are Smaller Banks a Good Investment?

The general picture I have been drawing of the banking industry is as follows: big banks are doing well; banks that are not big are not doing so well.

Who do I consider to be the big banks?

The big banks are the largest twenty-five domestically chartered banks in the United States and these banks hold two-thirds of the banking assets in the country. These banks, as a group, are doing very well.

The not-big banks are all the rest, some 8,000 domestically chartered banks that hold approximately one-third of the banking assets in the United States. These banks are not doing so well.

The evidence of the condition of these not-big banks is that the Federal Reserve is keeping its target rate of interest at 25 basis points or below and has pumped around $1.0 trillion in excess reserves into the banking system. The FDIC has approximately one out of every eight banks in the country on its problem bank list and is closing three to four banks, on average, every week. It is expected to continue at this pace for another 12 months or so.

Commercial banks are not making loans and this is true of the not-big banks as well as the big banks. In the not-big banks the problem seems to be dealing with the bad assets they have on their balance sheets rather than just an absence of potential borrowers.

Yet, within this environment, we hear and read about people, funds, or groups buying up the smaller banks and attempting to consolidate them into viable and vibrant regional banks…and possibly more. The New York Times on July 8ran an article on just this type of activity: “Financier Invests in a New Jersey Bank”, http://www.nytimes.com/2010/07/08/business/08bank.html?_r=1&ref=todayspaper.

Does this make sense?

My answer to this is “Yes, it does make a lot of sense!”

The New York Times article is about Wilbur L. Ross, Jr. who is expected to announce the purchase of a stake in the New Jersey banking company Sun Bancorp, an organization that has around $3.5 billion in assets.

Mr. Ross, according to the article, has predicted that “hundreds of the nation’s troubled banks will fail” and that there will be a substantial consolidation of the banking industry over the next few years. In earlier posts, I have also argued that the banking system, now at 8,000 banks, will consolidate, dropping to a total of no more than 5,000 banks in the next five years, maybe even a lot fewer.

Ross, who has already acquired banks in Florida and Michigan, stated that this acquisition could be the first of many he acquires in New Jersey.

“The next 18 banks in size (in New Jersey) after this one (Sun), together, have around $5 billion in deposits, and there’s another 100-some-odd banks that, in total have $40 billion in deposits.” Ross argues that “That’s just way too many banks for one state to have.”

The financial industry is changing. The largest twenty-five commercial banks in the country are going to be one thing. I believe that these banks will move from about two-thirds of the banking assets in the country to about three-fourths. They will be an entirely different animal of their own making. I have written many posts on what these banks might become in the Information Age.

The other one-fourth of the banking assets in the country will be in banks that are larger than the average not-big banks that now exist, but will be more “client-first” banks, banks that are more relationship based like the outstanding banks we knew in the past.

Certainly, these banks will change because they, too, are a part of the Information Age. However, they will not be the diversified financial giants inhabiting the territory of the largest twenty five big banks. But, this change to incorporate the technology of the Information Age will alter these smaller banks in a fundament, yet different way. More on these changes in future posts.

Aside: It is interesting that a new biography is just currently hitting the book stores, one that deals with an “old fashioned” banker who emphasized, successfully, doing business in the traditional way. See “High Financier” The Lives and Time of Siegmund Warburg” by Niall Ferguson. Yes, this is the Niall Ferguson that wrote “The Ascent of Money.”

I believe that there exists a tremendous opportunity in the restructuring that is currently taking place in the banking industry. Of course, one must not rush into these “deals” hastily for there are many problems that still exist within the industry. Remember, that is a major reason that the Federal Reserve is keeping interest rates so low. Also, there is the change in financial regulations that are currently being written in Washington, D. C.

Still, there is a major restructuring taking place in the banking industry and when such a restructuring takes place in an industry, opportunities abound. This is a chance to get in on the ground level with the “new” relations-based commercial banking platform. It is a chance to be a part of the new “Information Age” banking organization. And, to me, this restructuring is going to take place through the consolidation of existing banks so as to achieve the appropriate scale and geographic distribution of offices.

The consolidation of banks will not be achieved over night because of the time and energy it takes to put organizations together. Furthermore, many of the consolidating banks will have problems, these banking assets must be “turned around” as well as combined and this will take time and energy. But, it can be done.

Furthermore, these banks need to be “conservatively” run. That is, in my mind, the new banking rules and regulations will not be an impediment to success. I have been a part of three “turnarounds” myself, two as a CEO and one as a CFO, and have raised millions in capital. I always wanted these banks to have policies and procedures that were stricter than those imposed by the bank regulators because I did not want regulators to have a say in the decisions of the bank. Even within this “conservative” requirement, the banks were “turned around” and achieved attractive returns. This can also be achieved within the current environment.

Smaller banks can be a good investment and an organization intent upon building a 21st century, client-based commercial bank through the consolidation of these smaller banks, I believe, can be quite successful. This is certainly an area to keep an eye on.

Disclosure: I am now a board member of a startup organization, e3bank, attempting to build a 21st century, client-based bank. More information can be found on this bank at http://www.e3bank.com/.

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!

Federal Reserve Exit Watch: Part 11

The basic monetary facts are these: commercial banks aren’t lending and the money stock measures are not really growing. On the surface, it looks as if we have what Irving Fisher called, in the 1930s, the makings of a debt deflation. This is how we can interpret the statistics from the banking sector.

Contrary evidence comes from the performance of the “big banks”, the largest 25 domestically chartered commercial banks in the United States banking system. They are raking in profits right and left and are “making a killing” from the arbitrage and trading opportunities being subsidized for them by the Federal Reserve System.

The other 8,000 domestically chartered commercial banks in the United States are not doing so well. Roughly one out of every eight of these banks is on or very near the list of problem banks of the Federal Deposit Insurance Corporation. These are the banks that the Federal Reserve is trying to preserve through the low target interest rate policy it is following that is the ‘cash cow’ for the largest banks.

The Federal Reserve got us into this position by following a very destructive monetary policy in the early part of this decade. Then, once the financial system began to collapse, Chairman Ben Bernanke and the Federal Reserve threw everything it had against the wall to see what would stick.

We talk about financial innovation in the private sector! No group, organization, or institution initiated more financial innovation over the past fifty years than did the United States government and the Federal Reserve takes the individual prize for financial innovation during this period for what it did over the last three years or so. But, there was no real sophistication to the Fed’s financial innovation: the task of the Federal Reserve was to throw as much money as it could into the financial markets to protect the ‘liquidity’ of the market and its instruments.

Now the banking system (excuse me, the 8,000 ‘other’ domestically chartered commercial banks) is teetering on the brink of a ‘debt deflation’ (while the 25 large domestically chartered commercial banks are cleaning up) and the Federal Reserve cannot remove whatever ‘stuck’ to the wall from the banking system for fear that the rate of failure of the ‘smaller’ banks will accelerate.

The FDIC is overseeing the closure of approximately four commercial banks a week this year and the feeling is that this rate of failure could rise to five banks a week this summer or next fall. Analysts now expect the Fed will continue its “low interest rate target” into 2011.

Wow! The big banks are going to love this!!!

The ‘other side’ question is how is the Fed going to “get the stuff” that stuck on the wall, off the wall? That is, how is the Fed going to ‘exit’ its stance of excessive ease?

We are still waiting. The only ‘trick’ it has applied so far is to get the United States Treasury to
park funds in something called the “United States Treasury, supplementary financing account.” This account has risen by roughly $200 billion since the first of the year, $175 billion over the past 13 weeks, and this has drained some of the excess reserves from the banking system.

Again, no straight, classical monetary policy: the Fed used gimmicks…whoops, financial innovations…to get us to this point. Looks like we are going to use various gimmicks…whoops, financial innovations…to help get “the stuff” off the wall.

Excess reserves have declined about $80 billion from January, a little over $70 billion in the last 13 weeks, primarily due to the buildup in the Treasury’s supplementary financing account. Excess reserves, however, still are in excess of $1.0 trillion, averaging $1.048 trillion in the banking week ending June 2.

The only thing that the Federal Reserve has continued to do over the past quarter is to continue to increase its holdings of Mortgage-Backed securities. Over the last 13 weeks, the portfolio of Mortgage-Backed securities rose by $87 billion, $16 billion of the increase came over the past 4 weeks.

And, what impact does this seem to be having on the monetary aggregates. Well, the M2 money stock measure is hovering around a 1.6% year-over-year rate of growth. If the expected real rate of growth of the economy is around 3.0% then this monetary growth is certainly deflationary.

But, note this. The rate of growth of the non-M1 part of the M2 money stock measure was only 0.3% in May, on a year-over-year basis. The M1 year-over-year growth rate is 6.8% which shows that people are still transferring their wealth into transactions balances in order to have cash to pay for their daily needs. Given all the unemployment, foreclosures, and bankruptcies, the concern is that this movement will continue putting additional pressure on the 8,000 other domestically chartered commercial banks in the country.

The United States banking system does not seem to be healthy (except for the biggest banks). The monetary system is stalled. Ben Bernanke has traveled to Detroit, Michigan to hold a discussion about getting loans out to small businesses: see his “Brief Remarks at the Meeting on Addressing the Financing Needs of Michigan's Small Businesses, Detroit, Michigan” (http://www.federalreserve.gov/newsevents/speech/bernanke20100603a.htm). The Fed doesn’t seem to understand what is going on.

This is my eleventh post relating to the Federal Reserve’s Exit Strategy. I started these posts 10 months ago because of the concern expressed over how the Fed was going to “get the stuff” off the wall. The Fed wanted to be totally transparent about how it was going to “exit” its position of extreme ease and so it started talking about what it was going to do.

The concern is still there. As far as I can see, there is little confidence that the Fed can safely lead us to the “promised land”, the land of low unemployment, strong economic growth, and little or no inflation.

The Fed has acted with very little subtlety and sophistication over the past decade. Why should we expect it to act any differently over the next ten years, let alone over the next year?

Hotshot Traders Leave Street

Jenny Strasburg captures the mood on Wall Street in her article in the Wall Street Journal this morning: http://online.wsj.com/article/SB20001424052748704515704575282982462922628.html#mod=todays_us_money_and_investing.
“The competition is on to scoop up Wall Street traders and portfolio managers increasingly unnerved by the likelihood of sweeping new financial regulation.

Since political momentum began building earlier this year to limit trading for profit at Wall Street firms, traders have been exploring their options, and some have already left. Outside the banks, private investment funds looking for traders have been gearing up for a hot talent market.”

Economics works!

You change the incentives and people change…people move.

With the situation being more mobile than ever, with the technology more available and adaptable than ever, with the future more uncertain than ever…people…and the system…can change more rapidly and in more different directions than ever before.

And, that is what is happening!

This is one thing that Congress (and others) can’t seem to understand. Even after observing fifty years of the most dramatic financial innovation that has ever taken place in the world, the members of Congress seem to believe that they can “freeze” things, return to the past, and prevent the recent financial crisis from ever occurring again.

They also seem to think that the government is blameless from creating any incentives that might have a derogatory impact on the future that they want to create.

People in the Obama administration, as well as members of Congress, seem oblivious to the fact that over the last fifty years the United States government, Republicans and Democrats alike, produced a fiscal environment that created the incentives that led to a burst of innovative activity in the financial sector that produced massive changes in the way people did business and in the composition of the American economy. A brief picture of the environment.

From January 1961 through January 2009, the Gross Federal Debt of the United States rose at a compound annual rate of 7.7%. The monetized portion of the federal debt, the monetary base, rose at a compound rate of about 6.5% from January 1961 through August 2008, just before the Federal Reserve’s balance sheet exploded in response to the financial crisis that took place in the fall of 2008. The M2 money stock grew by more than a compound rate of 7.0% during the time period under review.

Thus, money and credit variables grew relatively in line with one another. Real GDP growth during this time was about a 3.4% compound rate of increase every year.

Prices, as measured by the Consumer Price Index and the GDP implicit price deflator, increased at a compound rate of about 4% during this time period resulting in a decline in the purchasing power of the dollar by around 85%. A 1961 dollar bill could only buy 15 cents worth of goods in 2008!

Inflation breeds financial innovation and the late 20th century with its relatively moderate, yet steady increase in prices, was a perfect environment for financial innovation!

The leader in financial innovation was the federal government itself, confirming what Niall Ferguson argues in his wonderful book, “The Ascent of Money: A Financial History of the World.” Ferguson claims that governments, historically, have been the primary financial innovator because of the need to fight wars. This, he continues, spilled over into the 20th century as governments needed to expand deficit financing to incorporate spending on social programs.

My guess is that in the next five to ten years we will see the biggest change in finance that we have ever seen and this change will be worldwide. I have written a little on this in a recent blog: “Changes Continue to Shakeup the Banking System”. See http://seekingalpha.com/article/200475-changes-continue-to-shake-up-the-banking-system.

The largest twenty-five banks in the United States, who control about two-thirds of U. S. banking assets in the country, are already changing their business. Again, they have already moved beyond what Congress and the administration are doing to regulate the banking system.

More important, foreign banks are changing the banking picture in the United States. Currently, foreign branches control about 11% of the total banking assets in the country. I have already stated that this will increase to 15% to 20% over the next five years or so. We see this expansion taking place before our eyes. Yesterday “China Finds a New Market for Loans: U. S.” (See http://online.wsj.com/article/SB10001424052748703957604575273011917977450.html#mod=todays_us_money_and_investing.) Today, “China Bank IPO, Possibly Biggest Ever, Set for July.” (See http://online.wsj.com/article/SB20001424052748704875604575281690877047522.html#mod=todays_us_money_and_investing.) And, don’t forget the sovereign wealth funds, huge accumulators of money.

The world of finance is changing because the incentives affecting finance are changing all over the world. I can’t even imagine what this world will look like with instantaneous trading, further ‘slicing and dicing’ of cash flows and other financial information, greater use of information theory to detect trading patterns (see my book review of “The Quants”, http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson), and more and more information markets popping up around the world (see Robert Shiller’s book “The New Financial Order: Risk in the 21st Century”)!

In the field of Complexity Theory, researchers speak of times like this when systems go through the process they call “Emergence” and “Self-Organization.” It is during times like these that one structural system is transitioning into another structural system. The problem is that no one, before-the-fact, can predict how existing information systems combine with other information to produce the resulting system. Systems just “self-organize” and a new system “emerges” from what was formerly un-organized.

This appears to be what is happening now. The movement of “hotshot” traders is one piece of evidence of this. The restructuring of the big banks is another piece of evidence. The response of hedge funds to the Congressional threat to change how partners are paid is evidence of this. The changes in financial regulations around the world is evidence of this. The growth and increased aggressiveness of Chinese banks is evidence of this. And, so on and so forth.

Congress is just speeding this change along. However, they better be careful about what they wish for because my best guess is that what they get will be nothing like what they are planning for.

"Risk-taking at banks will soon be larger than ever"

A new report has been released by the Roosevelt Institute and has been announced by ABC News:
http://abcnews.go.com/Business/economists-warn-financial-us-economy/story?id=9990828. The chief economist of this institute is the Nobel prize-winning economist Joseph Stiglitz. Also, on the panel that produced the report is Elizabeth Warren of Harvard and head of the congressional group that is overseeing the spending of the TARP funds, Simon Johnson of MIT, Robert Johnson of the United Nations Commission of Experts on Finance and Peter Boone from the Centre for Economic Performance.

A major forecast of the report is that “Risk-taking at banks will soon be larger than ever.”

I am shocked!

Aren’t you?

In my view, risk-taking at commercial banks, big commercial banks, was going strong by the summer of last year. It has grown since.

Why?

Thank you Mr. Bernanke and the Federal Reserve System!

Over the past year or so, we have seen the largest subsidization of the banking system in the history of the world!

No, I don’t mean the bailout money. I mean the money the banks have access to that costs less than 50 basis points!

There is, of course, a reason for the low interest rates. The small- and medium-sized banks in the country are is serious difficulty. See my posts, “The Struggles Continue for Commercial Banks,” http://seekingalpha.com/article/190191-the-struggles-continue-for-commercial-banks, and, “Reading Between the Lines on Bernanke’s Testimony,” http://seekingalpha.com/article/191159-reading-between-the-lines-on-bernanke-s-testimony. The concern here is that if the Fed began to remove reserves from the banking system, the great “undoing”, it would precipitate even more bank failures than are projected now, given the number of banks, 702, that are on the FDIC’s list of problem banks.

The large banks, however, the top twenty-five of which make up almost 60% of the commercial banking assets in the United States, are making out like bandits. And, why not when they can borrow for almost nothing and lend out at spreads of 350 basis points or so…risk free.

And, the dollar-trade continues to prosper internationally.

But, this is not regular bank lending, lending to businesses or consumers. Regular bank lending supports the expansion of the economy and employment of workers. That lending has been declining for months and it appears as if that lending will not pick up for many more months in the future.

The large banks were too big to fail and now the large banks produce huge profits because the Fed believes that the other 40% of the banking system is “too big” to fail.

And, what are these big banks doing?

I’m not sure that there is anyone else that knows the answer to this other than the banks themselves. I have said this over and over again beginning last summer. The big commercial banks are way beyond the regulatory system in terms of what they are doing, perhaps more so now than in normal times.

Regulation is ALWAYS behind the regulated. This is just a law of nature. The issue always is, how far behind the regulated are the regulators?

When I was in the Federal Reserve System, the estimate we used was that the Fed was about six months behind the commercial banks. The banks would try something to avoid regulations and the Fed would then have to find out what the banks were doing. Once the Fed found out they would then have to bring the “regs” up-to-date to close the loop-holes.

Last summer or so, I surmised that the commercial banks, after they had paid back the bailout money, moved ahead rapidly to take advantage of the subsidy they were receiving from the Federal Reserve in terms of exceedingly low interest rates. The subsequent profit explosion at the large banks seemed to justify my suspicions.

By the fall of 2009, I was convinced that these large banks were way ahead of the regulators in terms of what they were doing. For one, the regulators still had a financial crisis on their hands and were diverted from the “new” activity. Second, as is always the case, the politicians decided to fight the last war. Their battle cry: “We have got to stop the commercial banks from doing what they were doing.” Of course, that is why regulation is seldom very effective.

The Roosevelt Institute report calls for more financial reforms: re-regulate. Of course, Joe Stiglitz is one of the leaders in crying for new, more stringent regulation. Elizabeth Warren is there also. But, the picture I have just painted contains with it the conclusion that regulation never really is that effective because it is always behind the curve. However, if the rules and regulations are excessively restrictive then innovation and change may be delayed. (How long did it take to get the Glass-Steagall Act removed?)

In this world, the world of the Information Age, innovation and change is going to take place somewhere because, as I have said before, finance is just about 0s and 1s. (See my post “Financial Regulation is the Information Age,” http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.) My feeling is that regulation can delay but it cannot stop the changes the bankers want to make. If regulation delays the ability of commercial banks to innovate and change, the innovation and change will take place elsewhere in the world. And, funds will flow to where the innovation and change is taking place.

If the conclusion of this report is that “Risk-taking at banks will soon be larger than ever,” my question to the authors of this publication is: “Where have you been?”

The Banking System Continues to Shrink

According to the latest statistics of the Federal Reserve on the banking system, the banking system, as a whole, continues to shrink. Over the last 12 months, the total assets of all commercial banks in the United States banking system shrank by $560 billion or by about 5%. In the three months ending in January 2010, total bank assets dropped about $170 billion, with about $40 billion of the drop coming in January, itself.

Concern is still focused on the small- to medium-sized banks. Last week additional attention was focused specifically on 3,000 of these banks in terms of the problem loans they have on their books. (http://seekingalpha.com/article/188074-problem-loans-still-weighing-on-small-and-medium-sized-banks)

Elizabeth Warren, who heads the TARP oversight panel, is quoted as saying: “The banks that are on the front lines of small-business lending are about to get hit by a tidal wave of commercial-loan failures.”

There are a little more than 8,000 banks in the United States banking system and they had about $11.7 trillion in assets in January 2010. The largest 25 banks in terms of asset size held about $6.7 trillion in assets or about 57% of the assets in the banking system. “Small” domestically chartered banks held about $3.6 trillion in assets or around 31% of the assets in the United States banking system while the assets of foreign-related institutions amount to $1.4 trillion or 12% of the assets of the banking system.

So, there are a very large number of very small banking institutions that make up only about one-third of the bank assets in the country.

The total assets at these “small” banks dropped by $42 billion in January 2010, although by only about $14 billion in the last three months. The more interesting thing, however, is in the composition of this decline.

During this time period the loans and leases at these “small” banks fell by $20 billion in January and by $36 billion over the past three months. These banks are just not lending!

The primary decline came in real estate loans: they dropped $12 billion in January and $22 billion over the last quarter. We have, of course, heard of the problems these banks are facing with respect to commercial real estate loans and the numbers support this concern. At the “small” banks, commercial real estate loans fell by $10 billion in January and by $21 billion since October 2009.

Things were not very robust in other lending areas, but the declines reported in these other loans were not nearly so dramatic. I will call attention to the fact that consumer loans dropped by about $5 billion at these small institutions in January, a rather substantial decline.

Another indication of the difficulties “small” banks were facing is the decline in the securities portfolios at these institutions. Securities dropped by $31 billion in January, a time in which the “large” banks and the “foreign-related” banks both added securities to their asset portfolios.

And, where were the “small” banks building up their assets? In Cash Assets! Cash assets at “small” banks rose by $8 billion in January, and the increase totaled $21 billion over the last three months.

The smaller banks in the United States are putting more and more assets into cash as their balance sheets and loan balances shrink. This certainty supports the idea that many of these banks are in severe straits.

Large banks, on the other hand, actually reduced their holdings of cash assets in January by a whopping $71 billion. Over the past three months they reduced they cash assets by $118 billion.

These banks were not putting funds into loans, however. They were putting funds into their securities portfolio, adding $17 billion in January and increasing the portfolio by $60 billion over the last three months. The vast majority of these funds went into United States Treasury securities or federal agency securities. One can certainly sense a riskless arbitrage-type of strategy going on here.

Loans and leases at these large banks actually dropped in January by $46 billion, being spread fairly broadly over Commercial and Industrial loans (dropping $11 billion), Real Estate loans (dropping $18 billion) and Consumer loans (dropping $11 billion). It should be noted that in the consumer loan area there have been massive declines in credit card and revolving credit, $14 billion in January alone, but $27 billion over the last three months.

American commercial banks are not lending…period!

The largest banks seem to be living off of the riskless arbitrage situations that are available. They are doing little to nothing to help stimulate the economy along. But, why should they get into risky business and real estate loans when they can earn a pretty handy return without risking anything? Thank you, Mr. Bernanke!

The smaller banks seem to be drawing up the ramparts, becoming more and more conservative. This is where the loan problems are and the behavior of these organizations certainly lend credence to that belief. The fact that these banks are even getting out of their securities raises additional concern about the seriousness of their situation.

Note: The behavior of foreign-related institutions during this time period is also of concern. In the last three months, foreign-related institutions reduced their securities portfolio by $19 billion, their trading assets by $26 billion and their loans and leases by $33 billion, a total of $78 billion.

And where did they put the proceeds of this reduction in assets? They increased cash assets by $73 billion!

Foreign-related institutions in the banking week ending February 3, 2010, held $473 billion in cash assets, 38% of all the cash assets held by the banking system in the United States.

I don’t know right now, whether or not this fact should be a concern, but I would like to understand a little bit more about the situation of these banks. The “small” banks in the United States are moving in this direction because of the “poor” state of their loan portfolios. Is this move on the part of the foreign-related institutions of a similar nature? Or, are they going to move assets out of the United States?