Why Banks Aren't Lending

Remember the old story about commercial banks?  Commercial banks only lend to people who don’t need to borrow.

Well, that seems to be the “truth” about bank lending now.  The story going around is that the larger banks have increased their business lending, but the lending is really only going to those institutions that have a lot of cash on hand.  Otherwise, the commercial banks will sit on their excess reserves.

This also seems to be the story in Europe: commercial banks are just not lending anywhere. (http://www.nytimes.com/2011/09/23/business/global/financing-drought-for-european-banks-heightens-fears.html?ref=todayspaper)

And, the relevant question is not “Why aren’t commercial banks lending?”  The relevant question is “Why should commercial banks be lending at this time?”

The first reason why many banks shouldn’t be lending right now is that there is still a large number of banks who may be severely undercapitalized or insolvent.  Many commercial banks have assets on their balance sheets whose economic value is substantially below the value the asset is accounted for on that balance sheet.

The most notorious case of this is the sovereign debt issues carried on the balance sheets of many European banks.  The values that many of these banks have on their balance sheets for these assets have the credibility that the recent “stress tests” administered to more than 90 banks by European banking authorities. (Note that the European Union moved today to recapitalize 16 banks, http://www.ft.com/intl/cms/s/0/49d6240e-e527-11e0-bdb8-00144feabdc0.html#axzz1Yj4RAJ9F.)    

But, the problem is not limited to Europe.  How many assets on the books of American banks have values that need to be written down to more realistic market values.  For example, small- and medium-sized commercial banks in the United States have a large portion of their loan portfolios in commercial real estate loans.  The commercial real estate market is still experiencing a depression and market values continue to decline in many areas.  The write off of these loans can take large chunks out of the capital these banks are still reporting. 

The bottom line here is that commercial banks that still have problems are not willing to take on any more risk than they have to while they still have to “work out” these depreciated assets, or, at least, wait until the markets recover and asset values rise once again to former levels.  If you don’t make another loan…it will not go bad on you…so why take the risk of making a new loan.

And there are 865 commercial banks on the FDIC’s list of problem banks and many more surrounding that total that have not met the specific criteria of the FDIC to be considered a problem bank. 

The second reason why many banks shouldn’t be lending right now it that the net interest margin they can earn on loans is hardly sufficient to cover expense costs.  I have talked with many bankers now that say the only way to make any money through bank operations is to charge for transactions.  That is, to generate fee income. 

A general figure that represents the expense ratio of a bank is by taking expenses and dividing them by total assets.  Recent data indicate that this expense ratio is in excess of 3 percent, being around 3.15 percent to be more exact.  This means that on basic lending operations a commercial bank must earn a net interest margin of 3.15 percent in order to “break even”. 

Is there a problem here?  You betcha’!

Adding to this dilemma is the fact that the Federal Reserve has added on a new “operation twist” to the mix.  All these banks need is a flatter yield curve. (See my post http://seekingalpha.com/article/292286-will-bernanke-policy-destroy-credit-creation-bill-gross-is-worried-it-will.) 

There are two ways to respond to a flatter yield curve.  First, one can take on more risk in their lending. (See http://seekingalpha.com/article/293893-some-banks-are-stretching-for-risk.) Or, commercial banks can attempt to earn more money through additional fees, or principal investments (private equity or venture capital), or through the assumption of systematic risk taking. (See http://seekingalpha.com/article/292446-will-bernanke-policy-destroy-credit-creation.) 

Is this what the Fed wants?  The Fed seems to be caught in the bind that it must be seen as doing something, even though that something may not be very productive (QE2) or even counter productive (leading to bubbles and other speculative activity). 

The take on Fed behavior during the Great Depression has been that the central bank did not do enough.  Hence, Mr. Bernanke and crew are taking the position that history will not brand them with the same interpretation.  For the past three years they have operated so as to avoid the claim that they did not do everything in their power to counteract the forces causing a great recession, slow economic growth, or economic stagnation.

And, here they face the possibility of “unintended consequences”.  If the flattening of the yield curve results in even less bank lending than would have occurred otherwise, the Fed could actually be exacerbating the situation.  The stock market declined upon hearing the Fed’s policy.

The third reason why banks may not be lending now is the absence of loan demand.  Fifty years of government created credit inflation has resulted in excessive debt loads being carried by individuals, families, businesses, governments (at all levels) and not-for-profit institutions.  People, faced with under-employment, declining asset values, and income/wealth inequities, are attempting to de-leverage.  This de-leveraging will continue until people feel more comfortable with their debt loads, or, the Fed creates sufficient inflation so that people will start to take on more debt again. 

If the Fed achieves the latter, then we have returned to the credit inflation situation that has existed for the past fifty years.  This period of credit inflation has resulted in an 85 percent decline in the purchasing power of the dollar, more and more under-employment of labor, and greater income/wealth discrepancies within the society. 

The fourth reason is the uncertainty created in “the rules of the game.”  The Dodd-Frank financial reform act has created a great deal of uncertainty within the financial community.  For one, only about 25 percent of the regulations have actually been written and only a portion of these have passed.  As a consequence, commercial banks don’t know what rules they will have to follow…or, even more important, what rules they will have to find ways to circumvent.  Another new set of rules, these on taxation, were introduced by President Obama this week.  George Shultz, former Secretary of the Treasury, has argued that new, complex tax proposals not only lead to short-term uncertainty about what must be dealt with, but that over time “the wealthy and GE” will find ways to manipulate the tax laws in their favor. (See my posts of September 20 and 22:  http://maseportfolio.blogspot.com/.)  But, unfortunately, people, families and businesses, will devote time and resources to dealing with these “rules of the game” and not allocate this time and resources to more productive activities.

Again, I raise the question “Why should banks be lending?”, not the question “Why  aren’t banks lending?”   

The Future of Banking: Dodd-Frank at One Year

Well, we have suffered through one year of the new financial reform act passed in 2010.

“Some critics of the law contend that it skimped on the details, leaving regulatory agencies with too heavy a burden” having to write up the specific new rules and regulations.)  

Of the 400 new rules due from the reglators, only 12 percent have been finalized while 33 percent have missed the deadline set for their finalization.  There are still 55 percent of these rules that have a future deadline.

Barney Frank, co-author of the act, said Congress had no other choice.  “We didn’t punt anything.  It’s precisely because we knew we couldn’t get everything exactly right that we did leave room for the regulators.” (http://dealbook.nytimes.com/2011/07/20/barney-frank-financial-overhauls-defender-in-chief/?ref=todayspaper)

Part of this is because Frank…and others…didn’t really know what they were doing.  The article continues “Even he (Frank) concedes that arcane financial matters were never his strong point.” Frank jokes: “I know more now about repos and derivatives than I ever wanted to know.”

The result: we have a Congressional law, the Dodd-Frank Act, aimed at preventing 2008-2009 from happening again, written by people who knew little about banking and finance but had to do something to save the world from the people who ran Wall Street. 

The major concern of Congress was about institutions that were too big to fail.  These “large” banks were to create “living wills” that provided a blueprint of the organization’s operation that would allow regulators to dismantle the bank in an orderly fashion.  (These, of course, have not been written yet.)  And, there were other things about proprietary trading and derivatives and disclosure and so forth.

My conclusion from one year of Dodd-Frank is that the financial industry will survive…in some form…and will do very well over time although not in the way Congress will like.

I must admit, my awareness of the banking and finance industry began in the 1960s.  This was really the first decade that the laws and regulations coming out of the period of the Great Depression were really tested.  The 1940s was a period the United States was focused on war; and the 1950s were devoted toward the country getting back to some kind of normality following an era of world-wide depression and world war.

In the 1960s the fifty-year period of credit inflation got its start and this changed everything.

Since this period has spanned my professional career the evolution that took place is very real to me.  The period started out very calm and contained.  Banks were very limited in what they could do and they were especially constrained geographically.  There were unit banking states where a bank could only have one office; there were limited branching states where a bank could have multiple offices although the number were limited; and there were states that allowed state wide branching.  However, banks could not cross state lines and branch in other states!

There was a definite line between different types of financial institutions.  There were, of course, the commercial banks…and the savings and loan associations…and the mutual savings banks…and the investment banks…and so on and so forth.

The products and services offered by each type of institution were severly limited and closely regulated.  Interest rate ceilings were present to protect depository institutions engaging in “destructive” competition that would weaken the banking system. 

In my mind, two major things occurred as a result of the initiation of credit inflation in the early 1960s.  First, United States corporations grew bigger and bigger.  Second, international flows of capital were freed up from earlier constraints in order to support the growth of world trade. 

The consequence of this was that financial institutions, especially commercial banks, had to break out of their constraints so that they could serve there larger customers, both within the United States and in the world. 

Financial innovation began to roll.  The four biggest financial innovations that took place in the 1960s, I believe, were the formation of bank holding companies, the creation of the negotiable CD, the allowance of bank holding companies to issue banker’s acceptances, and the invention of the Eurodollar deposit.  These innovations basically over came state laws and allowed American commercial banks to become world bankers. 

By the start of the 1970s, state banking restrictions were effectively dead and the freed-up international flow of capital doomed the gold standard which was officially buried by President Richard Nixon on August 15, 1971 when the floated the United States dollar. 

As the credit inflation continued through the last half of the century financial engineering and financial innovation dominated just about everything else other than the growth of information technology.  Perhaps the final nail in the coffin of the 1930s financial regulation was delivered in 1999 as the United States Congress repealed the Glass-Steagall Act of 1933.  This was the act that separated commercial banking from investment banking into separate organizations.

My point in reviewing this history is to make the claim, again, that “economics works.”  If there is an economic reason for an individual or institution to “get around” laws and regulations, then that individual or institution will “get around” those laws and regulations.  Some laws and regulations will fall earlier than others but these latter laws and regulations will be circumvented over time as there develops more and more reason to do so.

In other posts I have argued that the banks that were too big to fail before are now bigger and more prominent than before the recent crash.  Also, financial institutions have already moved way beyond the “intent” of the Dodd-Frank Act in the areas that have the most economic promise, have “cooled it” in other areas, and in some areas where it has not really been worthwhile for them to fight they have relinquished those minor facilities. 

Especially in this “Information Age” finance and financial arrangements are going to be harder than ever to regulate and police.  Finance is nothing more than information, nothing more than 0s and 1s (see many of my posts in the past) and information can be “sliced and diced” almost any way one wants to slice and dice it and can flow, almost instantaneously, throughout the world.

The only thing of benefit that has come out of the new financial reform act has been some increases in transparency but this has not come anywhere close to the level I would like to see happen. 

These are some of the reasons for my conclusion of one year of Dodd-Frank that the financial system will survive.  However, the system that is evolving will be a lot different than what we see now and a lot different from what the Congress and the regulators would like to see.  Also, I am still predicting that the number of financial institutions in the system will drop below 4,000 (from a little less than 8,000 now) over the next five years. 

Let’s just hope that Congress and the regulators don’t chase most of the finance offshore.    

The Pace of Financial Overhaul

The writing of new financial regulations required by the Dodd-Frank financial reform act passed last summer seems to be dragging. “Regulators have missed or postponed several deadlines to write rules needed to implement the financial overhaul…” (http://professional.wsj.com/article/SB10001424052748704029704576087890419559076.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj)

The writing of such regulations in the world of modern finance is a very difficult and messy task at best and one that is even harder given the speed at which that world is changing. In some cases, definitions need to be revised such as who is an “accredited investor”; hearings are taking longer than expected; and disagreements need to be worked out. Furthermore, the regulation-writers are being careful because they “want to get it right.”

“In the next 18 months, U. S. regulators are supposed to issue more than 100 rules or studies in response to the Dodd-Frank law.” And, “The political deadlock in Congress over spending has left the SEC and CFTC without budget increases needed for the task.”

All this means to me, however, is that Congress and the regulators are just falling further and further behind which just makes what they are doing more and more irrelevant!

I have written many posts over the last two years or so about financial regulation and regulatory reform. Most of them have not been very encouraging concerning the positive benefits of the effort now going on to re-regulate the United States (and the world) banking system. The most comprehensive comment that I have made is that the re-regulation that is going on is already “out-of-date.” The reasons I give for this comment is that politicians and regulators are always fighting the last war and so start out behind and the bankers have already moved on into the future making the things being done even further “out-of-date.”

But, just notice three more bits of news that have been in the news in recent days, weeks, or months. First there is the phenomenon known as WikiLeaks. Not only has WikiLeaks “outed” the United States diplomatic system and threatened to disclose internal information said to be very embarrassing to certain United States banks, there is now the threat to expose 2,000 prominent individuals and companies that have been engaged in tax evasion and other possible criminal activity. This latter information was supposedly contained in two computer disks given on Monday to the founder of WikiLeaks by a former senior Swiss bank executive.

This “leaking” of information gets at one of the basic problems connected with information and information storage: security. The issue has to do with who has what information and who should be excluded from having certain information.

One of the fundamental ideas related to information theory is that “information spreads”. People try to control information and contain its spread, but this only slows down the speed at which information spreads…it doesn’t stop the spread.

Just ask the governments and religions that have tried to control information and thinking.

Just think of all the hackers out there. I very firmly believe in the “efficient markets” theory of hacking. That is, if someone can benefit in some way from hacking into a system, even to just embarass someone, they will find a way to successfully hack into that system.

Some information governments would not like others to have, like secrets related to national security. It was proven in the 1990s that all current “code” systems used to protect secrets are useless if someone has a Quantum Computer. Thus, a government like the United States believes that it needs to be “first” in creating a Quantum Computer so that it can keep these very important secrets. (http://seekingalpha.com/article/225773-the-new-world-order-smaller-and-faster-part-2)

My point is that in the world of information technology in the 21st century where information, even secret information, is so accessible, shouldn’t the government and the regulators show a little more interest in the openness and transparency of the financial institutions and the financial markets than it is showing.

The politicians and the regulators are looking for very specific outcomes. History shows that governments that try to force “outcomes” on a system NEVER SUCCEED!

It is remarkable how systems and markets are more able to regulate themselves if information is open and transparent to all. Maybe this is what Congress and the regulators should be emphasizing.

Second, there is the Goldman Sachs/Facebook transaction. Rather than have a public offering of shares in Facebook, Inc., where a substantial amount of information on the company would have to be forthcoming, Goldman decided that a private offering was better for the company at this time. Now, with concern that the focus on the private offering could be deemed “public” because of the intense attention given to the deal in the media could be considered a violation of U. S. securities laws, Goldman has decided to only offer the shares to non-United States investors.

My point here is that something is wrong with the regulations for such a “mess” to exist. First of all, what is “private” information and what is “public” information? Secondly, if others, like the media, can get sufficient information and publish it so that a “private” offering becomes a “public” offering even if the bank conducting the offering does not actively violate the law, what really is the definition of a “private offering”?

Third, in this global world, an offering such as the Facebook shares, can be taken “off-shore” as easily as sending an email out to potential investors. Should our laws and regulations be set up so as to “force” companies to go elsewhere in the world and escape onerous” regs” or “out-of-date” restrictions?

Fourth, in the information technology world we are moving into how can any financial offering be considered “private.” The possibilities that the “private” offering might become “public” are almost infinite.

Just one final tidbit: the Wall Street Journal article “Battle for Techies: Wall Street vs. Silicon Valley.” (http://professional.wsj.com/article/SB10001424052748704637704576082512439373244-lMyQjAxMTAxMDEwODExNDgyWj.html?mg=ep-wsj&mg=reno-wsj) The subtitle to this article is “Trading Companies Roll Out the Perks to Lure Top Talent; Shuffleboard, Paintball and, Yes, Higher pay; Outside the Bubble.” Wall Street believes it needs the best “techies” to compete in the modern world.

The point: information technology is very present in finance, after all, finance is just about information. Information technology is playing a bigger and bigger role in finance. 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, information technology is going to play an even bigger role in finance in the future.

Obviously, my belief is that the current efforts to write new rules and regulations for the financial area are on the wrong track and wasting a lot of money. But, these efforts are creating jobs and that is helping the economy. Maybe the financial reform bill was really just a stimulus bill in disguise

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!

Dodd-Frank Wall Street Reform and Consumer Protection Act

What do I think of the Dodd-Frank Financial Reform legislation?

I can't express it better than this:

The Dodd-Frank Financial Reform Act is already "legacy".