Fed Interested in "Cash" at Foreign-Related Financial Instituions

Seems like the Fed is interested in something I have been writing on for at least four months: the cash assets that “foreign-related (financial) institutions have been accumulating during the period referred to as QE2. (See http://seekingalpha.com/article/287494-foreign-related-financial-institutions-continue-to-suck-up-u-s-excess-reserves.)

Reporting this morning in the Wall Street Journal, David Enrich and Carrick Mollenkamp claim that the“Fed Eyes European Banks,” (http://professional.wsj.com/article/SB10001424053111904070604576514431203667092.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj). “Federal and state regulators, signaling their growing worry that Europe’s debt crisis could spill into the U. S. banking system, are intensifying their scrutiny f the U. S. arms of Europe’s biggest banks…”

“Officials at the New York Fed ‘are very concerned’ about European banks facing funding difficulties in the U. S…the worry is that the euro-zone debt crisis could eventually hinder the ability of European banks to fund loans and meet other financial obligations in the U. S.  While signs of stress are bubbling up, the problems aren’t yet approaching the severity of past crisis.”

Up to now, borrowing dollars hasn’t been a problem.  “Thanks partly to the Federal Reserve’s so-called quantitative easing program, huge amounts of dollars have been sloshing around the financial system, and much of it has landed at international banks, according to weekly Fed reports on bank balance sheets” 

This is just what I have been reporting since early this year. 

“Regulators are trying to guard against the possibility European banks that encounter trouble could siphon funds out of their U. S. arms.”

“Part of what is unsettling regulators and bankers is the speed at which funding can reverse direction.  This spring, foreign banks were able to build up ample cash cushions, thanks largely to quantitative easing…”

In July, 2010, non-U. S. banks had $418.7 billion on reserve and collecting interest at the Fed, according to Fed data.  By July 13 of this year, the total more than doubled, to about $900 billion.  Some major European banks were among the main drivers of this trend, according to their U. S. regulatory filings.”

Again, you could have read it here first.

“In recent weeks, though, the cash piles at foreign banks’ U. S. arms have diminished…foreign banks’ overall U. S. cash reserves fell to $758 billion as of Aug. 3, the latest data available.”

One note on this, the figures on cash assets at these foreign-related financial institutions can swing fairly dramatically from week-to-week and August, in banking non-seasonally adjusted statistical series, can be very interesting. 

Also, the buildup in cash assets at these foreign-related institutions began early enough this year that they could have been used for the “carry trade.”  Interest rates were so low in the United States that borrowing here and investing at the higher interest rates that could be found throughout the world was being done by most of the large financial institutions in the world. 

On June 28 of this year I wrote, “In essence, it appears as if much of the monetary stimulus generated by the Federal Reserve System went into the Eurodollar market. This is all part of the “Carry Trade” as foreign branches of an American bank could borrow dollars from the “home” bank creating a Eurodollar deposit. This Eurodollar deposit could be lent to foreign banks or investors and this would not change the immediate dollar holdings of the American bank. This lending and borrowing in Eurodollar deposits could then multiply throughout the world. And, the American bank might be the ‘foreign-related” institution mentioned above and included in the statistical reports.

Note that the original dollar deposit created by the Fed is still recorded as a deposit at one Federal Reserve bank no matter how much shifting around the borrowing and lending in the Eurodollar market occurs.

Thus, it appears as if the Federal Reserve pumped one-half a trillion dollars off-shore since the end of 2010!”  (See http://seekingalpha.com/article/276909-federal-reserve-money-continues-to-go-offshore.) 

So, there may be more than one reason for the build up of cash assets at the foreign-related institutions.  This is why we need to keep our eyes open and look at a wide-range of data. 

It’s interesting to me that the Fed did not seem worried at all about this cash buildup earlier this year even though the foreign-related institutions seemed to be siphoning off a lot of the funds the Fed was supplying to the banking system that was supposed to go into bank lending to get the economy moving again. 

Business Loans at Commercial Banks Continue to Rise

Commercial and Industrial loans in the banking system continue to rise.  Over the past thirteen week period business loans at all commercial banks in the United States increased by almost $37 billion.  These loans began a slight uptick last November and have been rising modestly since then.

Over the past four weeks, commercial and industrial loans have risen by about $16 billion. 

Up until recently the increase has been solely in the largest twenty-five banks in the country.  These large banks are still making the largest additions to the growth in business loans, but in the latest four-week period there seems to be some life in this kind of lending in the rest of the banking system. 

Of the $37 billion increase in business loans over the past thirteen weeks, $29 billion has come from the largest banks while $3 billion has come in the smaller banks and almost all of this latter increase came in the past four weeks. 

Real estate loans continue to drop although some leveling out in the larger banks seems to have occurred over the past month.  All real estate loans dropped by $65 billion over the last three months although they dropped by only $6 billion over the last month. 

Again, the largest balance sheet movements in the banking system came in cash assets. 

Over the past thirteen weeks, the cash assets in the banking system rose by about $415 billion while the total assets in the banking system rose by almost $500 billion. 

In the last four weeks, the cash assets in the banking system rose by a little less than $160 billion while the total assets in the banking system rose by about the same amount.

QE2 continues fund the banking system. 

There are some really important differences in the rise in cash assets, however, 

Over the past thirteen-week period, the cash assets at the largest twenty-five domestically chartered commercial banks dropped by $42 billion.  At the smaller domestically chartered banks, cash assets fell by $2 billion.

Cash assets at foreign-related financial institutions rose by almost $460 billion during this same time period! 

Over this past thirteen week period it appears as if all the excess reserves the Federal Reserve pumped into the banking system went directly into foreign-related financial institutions and…and…$44 billion of excess reserves already in the banking system found its way from domestically chartered banks into the hands of the foreign-related financial institutions!

Loans and leases at all domestically chartered commercial banks dropped by a small amount during this period of time. 

The summary: business lending seems to be getting stronger in the United States, but it is the only sign of life in the lending area in the domestically chartered commercial banks. 

The funds the Federal Reserve is pumping into the financial system is going directly into foreign-institutions in the United States and is going off-shore. (http://seekingalpha.com/article/273506-cash-assets-at-foreign-related-financial-institutions-in-the-u-s-approach-1t)

So much for monetary policy stimulus!

Cash Assets at Foreign-Related Financial Institutions in United States Approach $1.0 Trillion!

The Federal Reserve continues to pump reserves into the commercial banking system and the majority of these reserves are getting into the hands of foreign-related financial institutions and then heading offshore. 

On May 25, 2011, cash assets on the books of foreign-related financial institutions was just under $950 billion, up about $200 billion from April 27, 2011.  On May 4 cash asset at foreign-related financial institutions were 50 percent of all the cash assets held by commercial banks in the United States.

Now, on May 25, 55 percent of all the cash assets held by commercial banks in the United States were held by foreign-related financial institutions.

Please note, that on December 29, 2010, before QE2 really swung into action, these foreign-related institutions held only about one-third of all the cash assets on the balance sheets of commercial banks in the United States.

The increase from December 29 to the present has been roughly $590 billion. 

During this same period cash assets at all commercial banks rose by just under $660 billion, so that almost 90 percent of the cash assets pushed into the banking system by the Federal Reserve has gone into the coffers of foreign-related financial institutions!

From the Fed’s own balance sheet we see that Reserve Balances with Federal Reserve Banks, which closely tracks the excess reserves in the banking system, rose by $572 billion.  Almost all of this increase in excess reserves in the banking system has come about through the Fed’s acquisition of over $500 billion worth of U. S. Treasury securities. 

And, what have these foreign-related financial institutions done with the funds?

There is an account called “Net (Deposits) Due to Related Foreign Offices.”  On December 29, 2010 this account, on the reported statistics was a negative $420 billion.  That is, this was not money due to “related foreign offices” it was the money that “related foreign offices” had allocated to the United States office.  That is, it was an asset of the bank and not a deposit liability. 

On May 25, 2011, this negative number had turned into a positive number, it became a liability of the United States branches to “related foreign offices”, and this number was slightly over $86 billion.  This represented a swing of $506 billion!

In essence, cash assets at these foreign-related institutions rose by about $590 billion since December 29 and $506 billion of this increase went to “related foreign offices.” 

This looks a lot like the “pump” for the “carry trade”. (http://seekingalpha.com/article/270074-fed-continues-to-pump-reserves-into-foreign-related-institutions-in-the-u-s)

And, where do we pick up some of the results of this “carry trade” action?

Check out the Wall Street Journal last week, “Big Banks Cash In On Commodities,” (http://professional.wsj.com/article/SB10001424052702304563104576359704074143190.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj) “Wall Street is tapping a real gusher in 2011, as heightened volatility and higher prices of oil and other raw materials boost bank profits.” 

“A group of 10 large bans saw their commodities revenues increase by 55% in the first quarter. “

And, who says that the Federal Reserve is not underwriting world commodity inflation?  And, who says that the Federal Reserve is not underwriting the profitability of the big banks and producing even bigger banks that are too big to fail?

This is my July edition of the QE2 Watch, following up my June edition, see http://seekingalpha.com/article/268809-qe2-watch-banking-system-still-not-fully-engaged.  The Fed continues to do what it said it was going to do, purchase about $600 billion in U. S. Treasury securities by June 30, 2011. 

From December 29 through June 1, the Fed has purchased $516 billion U. S. Treasury securities.  Roughly $105 billion of these have gone to offset the decline in the Fed’s portfolio of Federal Agency Issues and Mortgage-backed securities.  Thus, the net increase in the Fed’s portfolio of securities has only been about $415 billion. 

But, the United States Treasury has drawn down $195 billion from its deposit account at the Fed related to “Supplemental Financing Account and this has put $195 billion of reserves into the banking system over the last five months.

The combination of the two, $415 billion and $195 billion, comes to $610 billion and accounts for all of the increase in reserve balances at Federal Reserve banks, the proxy for excess reserves, of $570 billion. 

The bottom line on this is that the Federal Reserve and the Treasury Department are seeing to it that the financial system is awash with liquidity…even though the largest amount of the funds are going offshore. 

The Small Banks Are Going Nowhere

Over the past six months or so the total assets of the smaller banks in the United States (smaller than the largest 25 banks) have remained relatively constant. Total assets averaged about $3.6 trillion in September 2010 and they averaged just below this number in March 2011.

And, given the Federal Reserve’s QE2 policy which has caused the cash assets of commercial banks in the United States to increase by almost $350 billion over this time period, the cash assets of these smaller banks remained roughly constant.

Over the past 13-week period, total assets at these smaller banks increased a modest $3 billion, but over the last 4-week span of time, total assets dropped by almost $10 billion.

Cash assets (over the past 13 weeks) rose by slightly more than $3 billion at a time when the total cash assets of the whole banking system were increasing by more than $480 billion.

The smaller commercial banking sector seems to be going nowhere.

What about credit extension amongst these banks?

Loans and leases at the smaller banks dropped by more than $8 billion over the last four weeks. The drop over the last thirteen weeks was slightly more than that.

And the largest 25 banks?

Total assets at the largest banks have increased by $60 billion over the past four weeks and by almost $90 billion over the last thirteen weeks. Most of the growth these largest institutions have come in cash assets. However, the increase in cash assets at the largest 25 banks in the United States has been small relative to the increase in the cash assets of foreign-related financial institutions in the United States. (See http://seekingalpha.com/article/262788-fed-s-monetary-policy-cannot-be-conducted-in-isolation.)

And, what about bank loans at these larger banks?

Since the end of 2010, loans and leases at commercial banks in the United States have declined by about $105 billion; and over the last four weeks of the first quarter, loans and leases at large commercial banks have declined by about $11 billion.

Business loans have rallied some over the last thirteen weeks, up a little more than $12 billion, but $10 billion of this increase has come in the last 4-week period.

Real estate loans have plummeted at commercial banks both over the last four weeks and the last thirteen weeks. The declines have come in both residential and commercial real estate loans.

And, what asset class, other than cash assets, has increased the most at the larger financial institutions? The securities portfolio.

So, the update on the banking industry as of the end of the first quarter of 2011?

The smaller banks, as a whole, continue to be in a holding pattern. And, QE2 seems to be doing little or nothing for these institutions. The cash reserves the Fed is pumping into the banking system is going to either the foreign-related financial institutions in the United States or the largest 25 commercial banks in the United States.

The smaller banks are not increasing their loan portfolios.

For the larger banks, QE2 is having some impact as cash reserves at the largest banks are increasing and the securities portfolios of these institutions are also increasing.

However, loans, as a whole, are not increasing…although there seems to have been a little pickup in the area of business loans.

Overall, one sees very little evidence that the Fed’s QE2 is having any impact on bank lending which, of course, does not provide much evidence that economic growth is going to begin accelerating in the near future.

Not very encouraging.

Almost One-Half of Cash Assets in Commercial Banks are Held by Foreign-Related Institutions

Check this out: on April 6, 2011, Commercial Bank Reserve Balances with Federal Reserve Banks totaled $1.503 trillion (Federal Reserve Release H.4.1); for the two weeks ending April 6, 2011, Excess Reserves at depository institutions in the United States averaged $1.431 trillion (Federal Reserve Release H.3); and on March 30, 2011 Cash Assets held by Commercial Banks in the United States were $1.558 trillion (Federal Reserve Release H.8).

All these measures of excess cash in the commercial banking system seem to center around $1.5 trillion.

The Federal Reserve also reports that on March 30, 2011 the cash assets held by Foreign-Related (banking) Institutions in the United States totaled $702 billion or right at 45 percent of the cash assets held by commercial banks in the United States on that date!

The Federal Reserve policy of Quantitative Easing (QE2) is supposed to spur on bank lending which, hopefully, will contribute to a faster growing economy and lower unemployment.

The published figures indicate that a very large portion of the funds the Fed is injecting into the economy is going into the “carry trade” and contributing to the spread of American liquidity throughout the world.

One rationale that has been given for the policy that the Fed has been following is that when commercial banks aren’t lending (that is, there is a liquidity trap), the Federal Reserve needs to inject as much liquidity into the banking system as possible until the banks begin to lend again. This is the essence of quantitative easing.

This rationale was developed by people who studied the history of the Great Depression. Milton Friedman contended that a central bank should follow such a policy when faced with a banking system that was not expanding the money stock. Professor Ben Bernanke also suggested that such a policy be followed.

However, in the current environment, there are two things that seem to be different from that earlier period. The first relates to the international mobility of capital: in the period around the 1930s nations did not support the free flow of capital throughout the world because the international financial system was based on the gold standard and foreign exchange rates fixed in terms of the price of gold.

Thus, with international capital flows constrained, it was argued that a country could keep a fixed foreign-exchange rate for its currency and conduct its economic policy independently of other countries, thereby allowing the country to focus on reducing unemployment to more acceptable levels. The policy prescription advocated by Friedman…and Bernanke…could, therefore, be followed within such a world without major foreign repercussions.

This is not the situation that exists now. Capital flows freely throughout the world.

The second factor is that there was no designated national currency that was designated as the “reserve currency” of the world. Thus, currencies were seen as either fixed in value or were allowed to freely float in foreign exchange markets. (I am not dealing with “dirty” floats and so forth at this time because they are related to currencies that are not designated as “reserve” currencies.)

And, since the United States dollar serves as the reserve currency of the world and, because of this, is the default currency when there is a “flight to quality” in world financial markets, the value of the dollar does not fall to the level that is needed to allow the Federal Reserve to conduct its monetary policy independently of all other nations.

The consequence is that the Federal Reserve is inflating the whole world!

It is great for the currency of a country to be the reserve currency of the world. However, being the reserve currency of the world carries with it responsibilities.

One of these responsibilities is that the United States cannot conduct its monetary policy independently of everyone else!

The value of the United States dollar is higher than it would be if it were not the reserve currency of the world. As a consequence, the behavior of the value of the United States dollar does not act exactly as if it were determined if it were a freely floating currency in the foreign exchange markets.

Therefore, the monetary policy of the Federal Reserve, given the free-flow of capital throughout the world, cannot be conducted in isolation.

We are seeing the result of this situation right before our eyes.

The Federal Reserve is pumping money like crazy into the commercial banking system. And, 45 percent of the money is ending up in foreign-related financial institutions.

This, I believe, is not what the Federal Reserve wanted.

This, I believe, is not what the people of the United States wants.

And, I believe, that this is not really what the rest of the world wants.

Still, QE2 continues, unabated.

Dynamic Portfolio Management and the Buildup of Cash

I am responding to a comment I received about one of my recent posts. The post related to the buildup of cash on the balance sheets of large commercial banks, large non-financial companies, and investment funds. The comment was:

“This giant 'pile of cash' is a myth. Check the other side of the balance sheet and you will see even more debt.”

In this post I will present the situation as I see it. I will use some of the concepts and arguments presented in the book “Financial Darwinism” by Leo Tilman which I just reviewed for Seeking Alpha. (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)

To begin with I argue that the managements of the large organizations mentioned in the first paragraph have adapted to the new world in which finance is looked on as a dynamic exercise rather than the static one that existed in the “Golden Age” of banking. In the dynamic world of finance, senior managements are constantly assessing and re-assessing the economic environment and adjusting their tactics and risk-taking strategies to match the financial environment as it changes due to variations in economic policy on the part of governments or economic shocks that can alter the trajectory of the business cycle.

About twenty months ago, the Federal Reserve decided that it needed to establish its target rate of interest in a range between zero and twenty-five basis points. And, the Fed decided that it needed to re-enforce this strategy by adding that it would continue to maintain this target range for “an extended time.” That was twenty months ago.

At the time, the yield on the ten-year Treasury bond was around 3.5%

Looking at this situation, senior managements could see that the financial terrain had changed. There was a real opportunity in the “carry trade” where they could borrow in the commercial paper market or in some other short term market for around 50 basis points and then buy Treasury securities that would yield them 350 basis points.

This meant that senior management could change its incremental business strategy, given the new circumstances, and earn a net spread of 300 basis points, RISK FREE. There was no credit risk because they would be investing in Treasury securities. And, there would be no interest rate risk because the Federal Reserve had promised that their interest rate policy would stay in effect for an “extended time.”

Tilman, in his book, refers to this kind of activity as “Balance Sheet Arbitrage” which is defined as “the ability of an institution to borrow at submarket levels.” This used to be the primary business of banks in the static world of banking, but had become less important in recent years as financial markets have changed and financial institutions have become more “intertwined.”

Certainly, however, there was an opportunity for senior managements to benefit from “Balance Sheet Arbitrage” within this new dynamic environment created by the monetary policy of the Federal Reserve. This was not a permanent change because the policy would only stay in effect for an “extended time”. Once the Fed allowed short term interest rates to rise again, interest rate risk would become a problem once again and the senior managements would have to re-assess and re-adjust their tactics in response to this changing environment.

While this Federal Reserve policy remained in place, commercial banks could do the following. On the liability side of its balance sheet, a bank could issue $1.0 billion in short term debt. The bank would then take the $1.0 billion and invest in 10-year Treasury securities. This investment, if my calculations are correct, would provide the bank with $30.0 million in profits, given the 300 basis point spread they could earn. The marginal costs of such a transaction would be miniscule so that we can basically ignore these expenses. But, now the bank has $30.0 million in “cash” which is covered on the other side of the balance sheet by an increase in net worth.

Instead of doing this the bank could write off $20.0 million in bad loans which would be taken against net worth, but the $30.0 in cash would still remain on the balance sheet. The $20.0 million write-off would not only improve the balance sheet of the bank but it would also reduce the taxes the bank would have to pay. This whole transaction would result in the bank earning a one percent return on its assets after taxes, something that most banks would not object to.

The ”giant pile of cash”, however, is not a myth. You can look on the other side of the balance sheet and “you will see even more debt.” However, in the “carry trade” you have investments that match up with this debt. This is how the “carry trade” works. The cash is “real”!

The important thing here, as Tilman argues, is that senior managements must change their strategies once the environment changes. The investments that resulted from the activity describe above were not obtained to “buy and hold” as banks did in the static world of banking. Once the environment changes, senior management must change as well.

What are we looking for here? We are looking for any indication that the Fed is going to change its monetary stance and allow short term interest rates to rise. Rising short term interest rates will also result in rising long term interest rates but the long term rates will generally not rise as rapidly as will the short term interest rates. The spread on the “carry” will lessen and could even turn negative. Senior managements will not want to continue this investment activity given a shift in the monetary policy of the Federal Reserve.

One other point that Tilman makes that I should mention. In such an environment where senior managements continually re-assess and re-position their organizations, “mark-to-market” or fair market accounting is a must. In the static world of finance where institutions bought and held investments, mark-to-market accounting was not as much of an issue as it is in the modern, dynamic world of finance.

In using the “carry trade” within the current policy regime of the Federal Reserve, these large organizations are taking advantage of the opportunities that exist within the “real time” financial markets. When the policy situation changes, they, too, must change their efforts: and this will mean selling off the assets.

If these organizations insist in accounting for these assets at purchase price they are deceiving themselves and deceiving their stakeholders. The risk that the Federal Reserve will change its policy stance exists. The senior managements of these organizations must accept the reality of this risk and reflect this in the changing market value of its assets. There is no way they can justify maintaining the accounting value of the assets as if they were in a “buy and hold” mode.

Furthermore, in a dynamic environment where the senior managements of banks are constantly re-assessing and re-adjusting their portfolios it is very difficult to justify some portion as assets that have been obtained to hold to maturity. This is another fall-out of moving to the dynamic world of finance. The lines between categories blur and it becomes harder and harder to make distinctions between what is something and what is something else. Since environments change, assets that were “honestly” purchased to hold to maturity may have to be sold. The risk of selling assets at a loss must be recognized by banks and presented to stakeholders in mark-to-market accounting.

Conclusion: large quantities of cash have been amassed on the balance sheets of big banks, big non-financial organizations, and big investment funds. This build up is not a “myth”. The buildup of cash has been subsidized by Mr. Bernanke and the Federal Reserve System. If would seem as if these large organizations owe Mr. Bernanke a big “thank you” for all he has done for them.

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!

Some Positive Movement in Small Bank Lending?

Could there be a glimmer of life in bank loans at Small Domestically Chartered Commercial Banks?

The latest figures released by the Federal Reserve on the Assets and Liabilities of Commercial Banks in the United States gives some indication that this is happening.
In the latest four weeks for which we have data, all Loans and Leases at commercial banks declined by $22 billion, but loans and leases at the smaller banks actually rose by $50 billion. And, this rise was across the board.

Note that over the last 13-week period, all loans and leases fell by $29 billion so that lending is down for the last quarter’s worth of data we have, but the figures reported above represent a movement in the right direction.

Furthermore, the increase in lending was across the board: commercial and industrial loans at these small banks rose by about $19 billion; real estate loans rose by $18 billion; and consumer loans increased by almost $17 billion. All these figures are down for the last 13-week period except for consumer loans that show an increase of about $14 billion for this longer period.

Are we getting a break in the ice barrier at the smaller banks? We’ll just have to wait and see.

Just an interesting side note on this: cash assets held by these same smaller banks actually declined by $17 billion during the last four weeks.

This occurred as the commercial banking system became even more awash with cash during this time period. Cash assets at Large Domestically Chartered banks rose by $88 billion and cash assets held by Foreign-Related Institutions rose by $192 billion. Total cash assets reported in the banking system reached a new high in the weeks of October 21 and October 28 of about $1.3 trillion while Reserve Balances with Federal Reserve Banks rose to $1.08 trillion on this last date and excess reserves averaged $1.06 trillion, a new record, for the two weeks ending November 4.

While the smaller commercial banks were increasing their loan portfolios during the last four weeks, large banks and foreign-related institutions were reducing theirs. For example, in the last four week period, large commercial banks reduced total loans by almost $52 billion. For the last 13-week period these banks have reduced all loans by $139 billion. And the decreases were all over the balance sheet: commercial and industrial loans were down by $27 billion; real estate loans were down by $40 billion; and consumer loans were down by $10 billion.

The only offsetting item on the balance sheets of the larger banks was an increase in securities held. This item rose $29 billion in the latest 4-week period; and was up by $68 billion over the last 13 weeks. This may be related to the fact that the largest reported area for earnings in the larger banks over the last calendar quarter or so came in the area of securities trading.

The securities portfolios of the smaller banks and the foreign-related institutions declined, both for the 4-week period and the 13-week period.

Overall, total assets in the banking system rose by $184 billion in the latest 4-week period, but that can be accounted for by the increase in cash assets. Total bank lending did not increase, and commercial and industrial loans and real estate loans continued to decline.

In this period, when everyone is looking for signs of a recovery, the fact that the lending at smaller commercial banks has shown some positive growth is encouraging. We will have to keep an eye on this area of the economy. Obviously, the lending at the smaller banks needs to pick up if the economy of “Main Street” is going to get started.

Furthermore, there has been great concern over possible solvency problems among the smaller banks. If these smaller banks are beginning to lend again and if they are drawing down their cash balances to do that lending, then that could indicate some increasing confidence within this sector that asset balances are beginning to stabilize. This would really be good news!

I don’t want to be premature on this, but, the increased lending of the smaller banks is a surprise and, possibly, a hopeful sign.

Yet, there are the larger banks. There is no indication that the decline in lending at the larger banks is going to stop. And, in one sense, why should it. Many of the larger banks are making lots of money off of security trading. The ones that are not in as good a shape continue to “down size” and contemplate which assets they want to sell off or which asset they can sell off. Apparently, continuing to stockpile cash assets and excess reserves is a good strategy for them. This, to me, is continuing evidence that the problem in these banks is one of solvency because the value of their assets cannot be determined.

The best news is still that things on the banking front are relatively quiet. Again, this is a sign that the banks are working through their problems. Yes, there is a bankruptcy here and a bank closing there. This news will not stop for another 12 to 18 months. Let’s just hope that things continue to stay quiet and these events proceed peacefully.

Banks Remain on the Sidelines

The commercial banking system is still holding onto cash rather than lending or investing. Over the thirteen weeks ending August 26, 2009 the assets of the banking system dropped by $246 billion, but the cash assets of the banking system rose by $87 billion. In the most recent four week period bank assets did rise by $85 billion, but cash assets at the banks rose by $183 billion during the same time span.

Overall, banks, during the last 13-week period, have reduced, at a more rapid pace, their holdings of loans and investments as write-offs have increased, as there has been little incentive to make new loans, and as the banks have gotten out of securities that are not issued or guaranteed by the U. S. government. This is evidence that the banks are de-leveraging and are attempting to clean up their balance sheets. More detail of this behavior is presented below.

The total amount of cash assets in the banking system was $1.1 trillion in the banking week of August 26. This amounted to 9.3% of the total assets in the banking system as total assets averaged $11.8 trillion for the week. Note that banks were required to hold an average of only $62 billion ($0.06 trillion) in reserves behind their deposits during the two week period ending August 26. The excess reserves in the banking system averaged around a whopping $0.8 trillion during this same two week period. (The peak level of excess reserves in the banking system was about $0.85 trillion in the month of May.) Also, note that bank reserve balances with Federal Reserve Banks averaged around $0.83 trillion in the banking week ending August 26.

Beginning in December 2008, the banking system has held an average of $0.76 trillion in excess reserves every succeeding month. Before September 2008, the banking system held, on average, $0.002 trillion in excess reserves. To put these figures in context, bank assets in the banking week of August 26, 2009 were only $0.8 trillion larger than they were in the banking week of August 27, 2008. Thus, the entire increase in bank assets over the previous 52-week period was in cash assets!

The banks certainly have not been lending or investing. Over the past 13 weeks, commercial banks reduced their holdings of securities by $335 billion and they also reduced their holdings of loans or leases by $237 billion.

The interesting shift in the investment portfolio is in government guaranteed mortgage-backed securities. These have been increasing over the past 13 weeks. (See the Wall Street Journal article “Banks Load Up on Mortgages, in New Way,” http://online.wsj.com/article/SB125253192129897239.html#mod=todays_us_money_and_investing.) The banks have also been purchasing U. S. Treasury and Agency (non-MBS securities) issues over the same time period.

The big decline in security holdings has been in Mortgage-backed securities that were not guaranteed by the federal government or a government agency. Here it is important to note that the banking system still holds more than $200 billion in non-government guaranteed mortgage-backed securities and over $700 billion in assets that include other asset-backed securities, other domestic and foreign debt securities, and investments in mutual funds and other equity securities with “readily determinable fair values.” The banks were obviously chasing yield by investing in these securities. Over 75% of these holdings are in large commercial banks with small banks primarily investing in this category in state and local government securities, although this may not be comforting.

The decline in loans and leases spans the board. Commercial and industrial loans are down by $57 billion in the last 13 weeks whereas these loans are down by only $68 billion over the past 52 weeks. This decline seems to be speeding up as the decline over the last four weeks totaled about $34 billion.

Real estate loans are actually higher now than they were a year ago, but the volume of these loans is now decreasing. Home equity loans are down by $9 billion over the previous 13 weeks, residential loans are down $40 billion over the same time period, and commercial real estate loans have fallen by $29 billion.

Consumer loans are about the same as a year ago, as is credit card debt and other revolving credit. However, these figures have shown weakness over the past three months with total consumer credit declining by about $39 billion and the credit card and revolving credit debt falling by about $26 billion.

The commercial banking system continues to restructure. It is maintaining high levels of cash and is moving into less risky interest earning assets. The banking system, net, is not lending. We continue to hope that the restructuring will continue to occur without further surprises. Strong economic recovery, however, will not occur with bankruptcies and foreclosures remaining at high levels and with unemployment continuing to increase. Banks are not going to lend into this environment.

The bottom line from this analysis: the economy is recovering but economic growth will be anemic. Economic growth will remain anemic as long as the banking system stays on the sidelines.