Bankers Expect Weak Profit Performance in the Future

The big bankers are projecting more bad news for their third quarter performance.  A discussion of this can be found in the New York Times article “Banks Brace for a Season of Fall-Offs” (http://www.nytimes.com/2011/09/14/business/wall-street-banks-bracing-for-drop-in-trading-revenue.html?_r=1&ref=business)

In what is taken as a reflection of the industry, JPMorgan Chase “warned that third-quarter trading revenue was likely to fall about 8 percent from a year ago.  Investment banking income is also expected to drop by one-third from a year earlier.” 

Note two things about this information.  First, the trading revenue does not come from the trading done by the banks, but from trading transactions initiated by the banks’ clients.  Second, the investment banking income relates to the fees earned on acquisitions and stock and debt offerings. 

As the economy recovered from the financial collapse, these sources of income provided an uplift for the troubled banking industry.  But, as we have seen, the revenues from these sources can show substantial swings from quarter-to-quarter due to the volatility of financial markets.  Now, activity is down and, according to Jes Staley, the head of JPMorgan’s investment bank, income from these sources could continue to be down in future quarters.

No mention here of basic commercial banking.  In fact, one has to go back a substantial amount of time in order to find anything about banking on Main Street.

Oh yes, there has been the noise about how the regulators are hurting or going to hurt bank performance by clamping down on debit card swipe fees and overdraft charges and credit card fees, but there is little or nothing on basic banking activity, like the financial intermediation that connects depositors to borrowers. 

Banking has become a business of collecting fees, whether on trading activity or stock and bond offerings or on business transactions connected with private equity and other types of principal investments. 

The good old business of banking, what Leo Tilman calls “Balance Sheet Arbitrage”, is not doing so well these days and has been declining in importance for years. (See Leo Tilman book, “Financial Darwinism” and my review of it 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.) As financial market efficiency has improved through increases in competition and advances in the Internet and information technology, more and more bank customers have achieved greater access to more and more sources of to serve their needs.  As a consequence, there has been a secular decline in the net interest margin banks can earn.

During this decline, in order to earn an acceptable return on “Balance Sheet Arbitrage” banks have taken on riskier loans, mismatched maturities, collected more and more fees, and used greater amounts of financial leverage. (http://seekingalpha.com/article/292446-will-bernanke-policy-destroy-credit-creation) Adding risk in this way was supported by the credit inflation policies of the federal government for the past 50 years.  However, this bubble has burst…at least, for the time being. 

The pressure on bank net interest margins will continue into the near future if the Federal Reserve keeps interest rates at their current lows for the next two years.  Adding a new “operation twist” to cause long term interest rates to fall further will only exacerbate the interest spreads earned by commercial banks and will perhaps stifle lending even further. (http://seekingalpha.com/article/292286-will-bernanke-policy-destroy-credit-creation-bill-gross-is-worried-it-will)

If these conditions continue, and regulations continue to put downward pressures on many profitable fee sources, banks will be forced to expand further into two other areas that Tilman has defined: Principal Investments (direct private equity and venture capital stakes, investments in hedge funds private equity stakes, or capital allocations to other proprietary investment opportunities) and Systematic Risk Vehicles (taking various risk positions in interest rates, credit, mortgage prepayments, currencies, commodities and equity indies).

I would like to make two comments about these developments.  First, the trends described here are only going to benefit the larger banks.  Most of these activities take trained and experienced individuals that achieve scale economies by being grouped in financially sophisticated organizations. 

Smaller financial organizations cannot afford to hire such expertise and cannot afford to build the departments that will house them.  When the smaller banks have tried to expand their businesses to incorporate these other sources of revenues they generally have gotten in way over their heads and have caused tremendous damage to institutions. 

An example, even from the 1990s: when I was brought in to turn-around a smaller bank during the nineties, I was shocked to find that the investment policy of the bank, approved by the board of directors, allowed the bank’s financial officer to engage in transactions that should only be done in the most sophisticated financial organization.  And, the bank only had one person, not that well trained, to conduct such sophisticated transactions. No wonder it was a troubled bank. 

Smaller banks, with net interest margins continually squeezed, will not be able to generate sufficient earnings to compete with their larger brethren.

Furthermore, banks are going to become less people intensive and will become driven more by information technology.  We are seeing the start of this…Bank of America reducing staff by 30,000 and HSBC laying off 40,000.  Other banks are also downsizing staff.  But, in my view, this is just a start because it is just reducing staff levels that were inflated otherwise.  The future, bank staffs are going to be cut even further as information technology takes over the banking industry.

The future?  Look two places: the first is the direction of banking in many emerging countries; and second, look at what your kids and grandchildren are doing.  Finance is just information.  For one, we don’t need massive branch systems to exchange information.   My children go into a branch, maybe once or twice a year…at most…and this reluctantly.  Their kids?  Don’t bet on them using physical banking facilities…anywhere.  And, look at the emerging nations with poor, spread out populations that historically have been under-banked.  It is truly remarkable the inroads that electronic banking is making in these areas.

I also believe that this second trend will be captured by the larger banks who again can scale up their efforts, both in terms of size of operation and in terms of technical sophistication, far better than can the smaller banks in the country. 

Basic banking, what Tilman calls “Balance Sheet Arbitrage” will continue to exist but in new forms and with changed margins.  But, the remaining banks will have to rely more and more on “Principal Investments” and “Systematic Risk Vehicles” and fees to generate adequate returns.  Putting a “ringfence” around the “Balance Sheet Arbitrage” activities to protect them, as the British have suggested doing, will not change the direction that banking is going. 

The question is “Do Bankers Get It?”

The Future of Banking--Once Again

Two recent newspaper articles, I believe, put into perspective the dilemma faced by commercial banks these days.  The first article is “Banks Face 2 More Years of Famine” in the Wall Street Journal. (http://professional.wsj.com/article/SB10001424053111903918104576500664173510794.html?mod=ITP_moneyandinvesting_9&mg=reno-secaucus-wsj) The second is “The Incredible Shrinking Banks” in the Financial Times. (http://www.ft.com/intl/cms/s/0/ce194584-c2b8-11e0-8cc7-00144feabdc0.html#axzz1Uj7mP9Rp)

The first article deals with the disappearing “net interest margin” at commercial banks and how the Fed policy of keeping the target Federal Funds rate in the 0.00 percent to 0.25 percent range until at least the middle of 2013. 

Commercial banks have historically made most of their money from the difference between the interest rates they charge on loans and the interest rates they pay on the funds they borrow.  This difference is called the “net interest margin”.   

This spread has, in general, been declining since the early 1960s.  Two factors have contributed to this decline.  First, one of the financial innovations of the 1960s was the movement of banks to engage of liability management.  Classically, commercial banks had been asset managers.  Bank liabilities were generally determined in local markets (because of the limitations on bank branching), were generally demand deposits, and were generally insensitive to interest rates.  Thus, banks were limited in the funds they had to lend by the amount of interest insensitive deposits they had on hand and the capital the bank had accumulated.  They did not manage this side of the balance sheet…it was a given.  Consequently, they were asset managers.

In the 1960s as capital began to flow more freely within states, between states, and between countries, banks, especially larger banks, could not live under the constraint of their liabilities and capital.  Loan demand began to exceed this constraint and so these large banks developed “market-based” liabilities that they could buy and sell at their will.  Thus, we had the creation of the negotiable Certificate of Deposit, the Eurodollar deposit, and the holding company issue of Bankers Acceptances.  Liability management took over at these banks. 

Liability management, early on, was limited to the largest banks.  But, as the financial system evolved, liability management migrated to smaller and smaller banks.  I must admit to some shock in that I just went through a training session on asset/liability management for commercial banks prepared for the American Bankers Association.  In this six-part program, the assumption was that every bank, even the smallest, engaged in liability management.  That is, even the smallest banks could go out and “buy” funds in the open-market and thereby fund all the loans that they might find.  Thus, the cost of their funds rose and well as their riskiness. 

The problem is, however, that deposits that are insensitive to interest rates pay a very low rate of interest.  Funds that are purchased in the open market pay “market rates” and are very sensitive to competitive rates.  Thus, the cost of funds for commercial banks rose relative to the interest rates on loans.  The “net interest margin” of commercial banks fell.  It thus became harder for banks to earn the returns they used to earn on “classical” banking business.

A second factor that contributed to the decline in banks “net interest margin” was the increased competition that came about over the last fifty years, both nationally and internationally.  “Good” borrowers could now go outside the banks limited banking region and find better and cheaper banking relationships.  As the limits on branching broke down, this competition for “good” customers increased.  As this competition increased, the “net interest margins” earned by the banks dropped even further. 

So, commercial banks, for years, have been facing falling “margins.”  Now, as the Wall Street Journal article proclaims, the Fed put even greater compression on interest margins over the past couple of years by reducing its target Federal Funds rate to the 0.00 percent to 0.25 percent range.  With the new policy decision to keep this target so low for another 24 months the Fed has basically “locked in” exceedingly low “net interest margins”.  The article supports this claim by looking at Treasury yields: the spread between the two-year Treasury yield and the 3-month Treasury yield is just 19 basis points (this spread was 46 basis points three weeks ago); the spread between the five-year Treasury and the 3-month Treasury is less than one percent (a month ago this spread was 150 basis points).

“For the biggest banks, this decline in the net interest margin cuts into profits from lending as well as crimping investing and trading income.  Smaller banks face the added challenge of often having to pay more to attract funds.”

The thing that struck me about the Financial Times article is this: the British bank HSBC and Google have roughly similar market capitalizations.  “The striking difference is that Google generates these number with fewer than 30,000 employees—not even as may people as HSBC is laying off.”  HSBE recently announced that it is laying off a 10^th of its workforce, 30,000 redundant employees. 

Both companies deal with “information”.  Finance (money) is just information.  Whether it be paper or gold or 0s and 1s, it is just information.  The “value” of the paper or gold or 0s and 1s comes from the ability of this paper or gold or 0s and 1s to acquire something that we want to buy.  This is why information technology is such an important part of commercial banking.

What do I see for the future?  I have written about this many times in many places over the last five years.  You can find many of my blog posts on Seeking Alpha. (http://seekingalpha.com/author/john-m-mason?source=search_general&s=john-m-mason)

And, the author, Frank Partnoy, makes this point in his Financial Times article.  Commercial banks deal with information and Google deals with information.  Yet in the case of HSBC we see that Google has a workforce of less than one-tenth of that of HSBC and they both have the same market capitalization.  The question is, why does HSBC have such a large workforce? Partnoy adds: “Facebook’s equity is worth more than that of most banks, yet it has just 2,000 employees.”  Where is the adjustment going to come?

Because commercial banks have experienced falling net interest margins and because they have a business model that is way out of date with the existing technology, commercial banks have had to do other, riskier things to “make their money.”  The commercial banks have “expanded into riskier and more complex activities, including structured finance, derivatives trading and regulatory arbitrage, which can allocate capital in distorted ways.”  In essence banks have had to make up for their inefficiencies by taking on more financial risk, increasing financial leverage, and through financial innovation. 

The consequence?  Commercial banks, in Europe as well as in the United States, are troubled.  Many banks are selling at discounts from their book values, something at substantial discounts.  The inherited banking model does not seem to be working and something new must take its place.  What will the new model be?   

Obviously, we are in the process of working this out.  One thing seems sure to me. Banks in the future are going to employ a lot fewer people per dollar of assets than they have in the past.  I don’t know whether Google or Facebook are the models of the future, but information technology will have a dramatic effect on the finance industry over the next five years or so.  Furthermore, banks can’t live off of recently experienced or current net interest margins.  Here we might get a bifurcation of the banking industry into something like commercially orientated banks and consumer oriented credit unions.  We’ll see.   

The Number of Problem Banks Continues to Rise. Surprise!

The most important thing for government regulators at this time is to handle the problems in the banking industry in an orderly fashion. Don’t panic; don’t show fear; just keep plugging ahead.

This seems to be exactly what the FDIC and the Federal Reserve are doing.

The FDIC announced that there are now 829 banks on the problem watch list as of June 30, 2010. Given that 45 banks failed in the second quarter of 2010 this means that 99 additional banks were added to the list. One should note that this figure, 99 banks, compares with 113 banks that were added to the list in the first quarter of 2010. The highest number ever reached for the problem list was 993 and this came in 1993.

Remember, though, that Elizabeth Warren indicated in Congressional testimony that there were 3,000 banks that faced serious problems with respect to loans and assets on their books that probably needed to be written down and that these banks had not seen the full effect of the problems in the commercial real estate sector.

One can also add that these institutions have not really recognized the problems that state and local governments are having in their finances. Note that Pennsylvania’s capital, Harrisburg, announced that it will default on a $3.29 million municipal-bond payment in two weeks making it the second largest general-obligation municipal bond default this year.

With the 32 banks that have failed so far in the third quarter, the total number of failures in the year reached 118, well ahead of the pace from last year when only 140 banks were closed overall.

Using the rule of thumb that one-third of the banks on the problem list will fail over the next 18 months, this would mean that we will experience 276 more bank failures and an average rate of bank failures at 3.5 per week during this time span. In 2010, the pace of bank failures has hovered around this average.

But, the FDIC is working through this tremendous case load in an orderly fashion. There are very few surprises and this is the best thing that can happen given the condition of the banking system.

The Federal Reserve is also contributing to this work out situation in the banking industry. Perhaps the most important thing it is doing is the subsidization of the large banks in the United States. By keeping its target interest rate around zero percent, the Fed is paying a big bonus to the big banks and the payoff for this policy is that the profits at the largest financial institutions have been at record levels and that about 75 percent of the assets of the banking system seem to be well protected.

The profit picture of the banking industry improved in the second quarter with the industry recording the highest level of profits since before the financial crisis. The FDIC reported that nearly two-thirds of United States banks reported a year-over-year improvement. The biggest booster to this performance was the reduction loan-loss provisions.

However, it should be noted that 20 percent of the banks, primarily the smaller banks, reported a net loss and that more than 60 percent of banks, mainly the smaller institutions, continued to increase their loan loss reserves.

Another place where one can find information on the problems the commercial banking industry is having is the report of the Federal Reserve on Enforcement Actions taken by Federal Reserve Banks against some of the financial institutions it regulates.

So far in the third quarter of 2010, the Federal Reserve has engaged in 56 enforcement actions against financial institutions bringing the total up to 192 for the full year to date. Last year only 172 enforcement actions were taken.

Enforcement actions can take one of two forms: a written agreement or a prompt corrective action directive.

The most recent written agreement is a legal action taken by the Federal Reserve Bank of Kansas City, the State of Colorado Division of Banking and First American Bancorp and First American State Bank, both of Greenwood Village, Colorado. This written agreement aims to bring the banks into compliance with every “applicable provision” of the Agreement reached between “the Bancorp, the Bank, and their institution-affiliated parties”, the Reserve Bank and the Division. The agreement specifically deals with Board Oversight, Credit Risk Management, Lending and Credit Administration, Asset Improvement, Internal Audit, Allowance for Loan and Lease Losses, Capital Plan, Earnings Plan and Budget, Liquidity/Funds Management, Dividends and Distributions, Debt and Stock Redemptions, Cash Flow, and, Compliance with Laws and Regulations. The specifics of each of these sections present a very definite list of things the bank(s) must do in order to comply with the agreement. Furthermore, specific dates are given for achieving compliance. And, “The provisions of this Agreement shall not bar, estop, or otherwise prevent the Board of Governors, the Reserve Bank, the Division or any other federal or state agency from taking any other action affecting” the affected parties or this successors and assigns.

The most recent Prompt Corrective Action is that taken against the First Community Bank of Taos, New Mexico. In this agreement very specific actions are required such to “increase the Bank’s equity” and to “enter into and close a contract to be acquired by a depository institutions holding company or combine with another insured depository institution.” The Bank is restricted from making capital distributions or the payment of dividends. The Bank shall not “solicit and accept new deposit accounts, etc.. The Bank shall restrict the payment of bonuses to senior executive officers and increases in compensation of such officers.” And, the bank is restricted in terms of asset growth, acquisitions, branching, and new lines of business.

These enforcement actions are very serious and a reading of some of them can give one an idea of the problems that exist “out there” in the banking industry. And, 192 of these have been given out so far this year!

As more and more information is made available, the more one realizes that the banking industry is being re-constructed. In the next five years or so we will observe a banking industry that is much smaller than the one that exists today and this industry will be even more dominated by the larger institutions making up the industry. I believe that the number of domestically chartered banks in the United States will fall from a present level of about 7,800 banks to around 4,000 banks. I believe that the largest 25 domestically chartered banks in the United States will control about 75 percent of the banking assets in the country up from around 67 percent now.

I am more confident about this latter number than the former one. It is hard to believe that 3,975 banks can profitably be operated when they only control 25 percent of the banking assets. The smaller banks are just not going to be profitable and cannot compete in the world of the 21st century!

Tax Evasion?

In the last few days we have seen a ton of headlines and articles talking about how President Obama is going to tax the major banks of the country (including US branches of foreign banks) in order to recoup the bailout funds paid to the banks that went to save them.

The President pledged to “recover every single dime the American people are owed.”

Remember that Mr. Obama is the protector of the dime since he vowed that the health care plan would not cost the American public “one dime”!

The estimated bottom-line cost to the banking system is about $100 billion over a ten-year period.

The banking system is, of course, lobbying as hard as it can to prevent such a tax from being levied. And, lobbyists are earning a lot of money off of this.

But, the President has heard the voice of the little people who are angry at the bankers.

Oh, and then there is the need for new bank regulation.

The estimated cost of this new regulation is in the billions of dollars.

The banking system is, of course, lobbying as hard as it can to prevent such regulation from being inacted. And, lobbyists are earning a lot of money off of this.

But, the President has heard the voice of the little people who are angry at the bankers.

What can we bet on?

My experience in running banks and in studying banks and the banking industry is that the big banks will not, ultimately, pay much of the bill at all.

The reason for this is that the banks will find many, many ways to get around any new laws, regulations, and taxes or will pass the cost of the new laws, regulations, and taxes on to others.

Let me just say here that I don’t mean to single out just the banks in this area. In this Age of Information and with a global network of business and finance almost everyone that has wealth or financial clout or is big can find ways to avoid laws, regulations, and taxes. And, if you don’t believe this it just shows how good these people and organizations are at evading them.

And, the people and organizations that can evade or avoid these new laws, regulations, and taxes the best are the ones that the President and the “populists” are after. The people and businesses that are the least able to avoid the new laws, regulations, and taxes are those that can least afford the consequences of the new laws, regulations, and taxes. This will include the small- and medium-sized banks and people from Main Street. This has happened over and over again throughout history.

Just an example: in the 1960s it was almost the mantra of a certain brand of economist that a little inflation (an inflation tax, if you will) would help the “little people” because it would result in more employment. This was captured in something called “the Phillips Curve.”

The result? In the short run employment was a little higher but people found that inflationary expectations adjusted and over a longer period of time it took more and more inflation to sustain the small rise in employment associated with the higher inflation. By the end of the 1970s we had a real crisis!

Furthermore, those with more wealth or who were better connected could protect themselves from inflation. They could purchase assets, like homes, and art, and securities that appreciated in value with increases in prices. The less well-to-do or the less well-connected could not do this and so the wealth distribution in the country became more skewed.

Thirdly, higher and higher inflation affects productivity and this impacted the use of existing capital and the hiring of the less educated and less trained worker. Unused capacity in manufacturing and under-employment rose over time again hurting those that were the least able to protect themselves.

The purchasing power of the dollar declined from 1961 to the present: where one dollar could buy one dollar’s worth of goods at the former time, it could only buy 17 cents worth of goods now. And, who has suffered the most? Main Street and not Wall Street!

There are two forces dominating the banking scene right now and neither one of them can lead to the construction of sound banking regulations and banking practices. The first is the emotion of the present. People may be upset about what has happened and are particularly incensed at the profits that the large banks are posting. However, an emotional response to current events cannot lead to a rational result. Basing laws, regulations, and taxes on a populist outburst will only produce consequences that are regretted in the future.

Second, it has been my observation that politicians only fight the last war. This is popular because the “last war” is discussed in the press and it is what the constituents of the politicians are responding to. Furthermore, the issues are so complex that the politicians don’t even understand what happened in the “last war”. If you don’t believe this take a look at the initial work the Financial Crisis Inquiry Commission.

Finally, the big banks that the politicians are going after have already moved on “light years” ahead of what happened in the “last war”. I have written several posts on this very fact. Thus, the politicians are firing at the wake of a rapidly moving boat and will miss their target by a lot!

Oh, well, politicians have to get their 15 minutes of fame and try and get re-elected: Seems like we could spend our time concentrating of more productive efforts.

BIG BANK PROFITS

If anyone should be congratulated for the massive profits that have been posted by the “big banks” over the past nine months it should be Ben Bernanke and the Federal Reserve System. Since the real strength of the earnings, especially in banks like JPMorgan Chase, have been in investment banking and trading, one can argue that the Federal Reserve policy of keeping short-term interest rates near zero has subsidized the pockets of the big bankers. Thus one could ask if any of the huge bonuses being paid out by the “big banks” are going to the Chairman and his officers in the Federal Reserve System. They certainly deserve them!

Banking, Banks, and the President: Defining the Issues

The side that wins the political battles is usually the one that presents the issues in such a way that the “public” responds to this presentation and goes with them rather than with the “other side.”

There is an election coming up next year and the campaigning has already begun. The battle: whether or not the Democrats are going to be able to maintain a large enough majority in Congress to control the action in Washington, D. C. Already, the Democrats are looking back over their shoulders to 1994 mid-term election and their loss of control of Congress at that time. And, they are scared.

The way to operate in politics is to “frame” important issues in such a way that they will resonate with a majority of the electorate. It takes time for specific issues to “take hold” with the public so the framing effort must be started well in advance of the election. The process of “framing” is moving ahead, full steam.

The economy is obviously going to be an issue. How it is framed will determine the result. It appears that the banking industry is going to play a big role in how the discussion on the
economy evolves. The battle lines: Main Street versus Wall Street. The issues: an unemployment rate of 10% and an underemployment rate at 17-18% versus lots of taxpayer money to bail out the banks and the subsequent profitability of the big banks. A further issue: people losing their homes through foreclosure versus the payment of large bonuses by the big banks to their executives.

Sure the meeting between the President and the heads of the major banks in the United States was a great photo op. But, what did the photo op turn into? Let me just say that a headline like “Bankers Put Obama on Hold” accompanied by a picture of the President at his desk holding a phone does not create a very favorable image of the bankers (see the article by Andrew Ross Sorkin in the New York Times: http://www.nytimes.com/2009/12/15/business/15sorkin.html?_r=1).

Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System, is still a hero to many people, myself included, and is perhaps the most respected person in finance in the world today. He stated very bluntly in West Sussex, England this week that the bankers just didn’t get it. Great headlines!

In debates like this it doesn’t always matter who is right and who is wrong. We have seen over and over again that in economics, identifying the cause and effect of an economic situation is so difficult and the lags between the cause and the effect are so long, that explaining a situation to the public in terms that they understand is almost impossible.

Here I am specifically writing about the run-up to the financial collapse of 2008. To me the causes of this collapse go back to the almost 50 years of inflationary finance perpetrated by the United States government, Republican and Democratic alike, on the American people. This includes the huge deficits run up by the federal government since 9/11 and the inexcusable monetary ease that kept real interest rates negative for two to three years in the 2002-2005 period. The financial bubbles that resulted in housing and the stock market this decade produced the conditions that led to the subsequent events.

An economy with an inflationary bias is ideal for the evolution of financial innovation. It is ideal for leveraging up the balance sheet. It is ideal for assuming more and more risk.

It is difficult, however, to explain this cause and effect to the public.

Financial innovation looks like greed run amok. Assuming more and more risk looks like greed run amok. And, excessive amounts of leverage looks like greed run amok.

But, what about the government policy makers that created the incentives that made financial innovation valuable? What about those that contributed to the inflation that made high degrees of leverage worthwhile and edgy risk taking more attractive?

The connection is very difficult to put into sound bites and win the hearts and minds of voters.

In terms of financial regulation? My belief is that banks, especially the big banks have moved beyond the recent financial collapse. Congress and the regulators are always fighting the last war. The goal of Congress and the regulators is to not let the events of 2008 and 2009 happen again.

Guess what? The events of 2008 and 2009 will not happen again. The banks have moved beyond that. The reformed regulations will probably hurt the smaller banks much more than the larger banks. The smaller banks are still the ones dealing with the past, the questionable commercial real estate loans, the residential mortgages that are in arrears or are not paying at all, the consumer credit, the credit of state and local governments and so on and so on.

But, the big banks. They are already into 2010 and 2011 and beyond! More on this in another post.

This is why the banking industry must be careful at this time. In a real sense, Volcker is right; the bankers just don’t get it!

They can’t afford to look as if they are making the President look silly. They can’t afford to make themselves look like they are “fat cats.” Whoops, that is what the President called them Sunday night and it is all over the country. The bankers can’t afford to look as if they are staunchly against regulation reform. The bankers can’t look like they don’t care about mortgage foreclosures, or small-business loans, or getting people back to work.

The issues are being “framed” right now. The bankers cannot put themselves in a position to be characterized as “Scrooge” while the Obama administration comes on as “Tiny Tim.”

Big Banks seem to be doing just fine: Smaller Banks, not so well

Last month it seemed as if there was a glimmer of hope for the smaller banks: lending appeared to be picking up across the board. (See my November 9 post, “A Positive Trend in Small Bank Lending”: http://seekingalpha.com/article/172219-a-positive-trend-in-small-bank-lending.)

Well, the glimmer of hope went away in November. However, lending, and profits, at the larger banks seemed to become more robust as we went deeper into the fall.

Overall, bank liquidity continued to rise as the cash assets in the commercial banking system rose by $290 billion in the latest 13-week period and by $110 billion in the last 4-week period. This increase was, of course, reflected in the aggregate bank data. The Federal Reserve showed that Reserve Balances with Federal Reserve Banks averaged $833 billion in the banking week ending August 26, $1.085 trillion in the banking week ending October 28, and $1.139 trillion in the banking week ending December 2. Excess reserves in the banking system averaged $795 billion, $987 billion, and $1.120 trillion for the two-week periods ending, August 26, October 21, December, respectively. The banking system became more liquid as the fall matured.

Whereas, lending in the smaller banks showed some rise in October, lending was down across the board in the November period and this seemed to drag down the results from the last 13-week period.

The leader in this decline was lending for Commercial Real Estate. Analysts have claimed for some time now that problems were looming in this area for the small- and medium-sized banks. The concern was over timing: when were the problems being experienced by this sector going to show up on the balance sheets of these banking organizations?

Well, they really seem to be showing up now. Commercial Real Estate loans on the balance sheets of “small” domestically chartered commercial banks declined by $33 billion in the 4-week period ending November 25. They dropped by $50 billion in the last 13-week period.

Commercial and Industrial loans also decreased at the smaller banks in the latest 4-week period by $23 billion. (These loans actually had increased in the previous nine weeks.)

Furthermore, as stated in my December 1 post, these small- and medium-sized banks are not doing well profit-wise. The F. D. I. C. reported that commercial banks of $1.0 billion in assets size or less roughly broke even profit-wise in the third quarter of 2009. Banks in the $1.0 billion to $10.0 billion in asset size lost, on average, $3.0 million per bank in the third quarter.

The problem bank list, which consists primarily of small- and medium-sized banks rose to 552 at the end of the third quarter, an increase from a total of 416 at the end of the second quarter, and this is with 50 banks dropping off the list in the third quarter because they failed. (This information is reported in http://seekingalpha.com/article/175958-banking-sector-weakness-the-secret-no-one-wants-to-talk-about.)

The blip upwards in lending at the small- and medium-sized commercial banks reported last month is typical of the information flows we are getting these days. Some months the information that is reported looks good and we get excited about it. The next month…well, the information isn’t so good. The concern with the smaller banks is that the future could really be quite bleak.

With 552 banks on the F. D. I. C. problem list, we could see the banking industry taking a lot of hits in the next 12 months or so. If one-third of these banks fail, which is the estimate going around, this would mean that 184 of these banks would be closed or, in a 12-month period, roughly 3.5 banks per week would be closed. In the third quarter of 2009 three banks a week, on average, were closed. And, this assumes that no other banks come onto the problem bank list.

What about the big banks?

The big banks, except Citigroup, seem to be doing just fine. Even Bank of America is going to pay back the money it received from the federal government and it has raised additional capital.

Evidence that big banks are doing OK is present in the F. D. I. C. data just released. Commercial banks with assets in excess of $10 billion reported profits, on average, of $42 million per bank in the third quarter.

This prosperity seems to be translating itself into the performance of these larger banks. The assets of large commercial banks rose by $202 billion in the last 4-week period, whereas total assets actually dropped in the smaller banks and in foreign-related banking offices.

Loans and leases at the bigger banks surged by $163 billion in the last four weeks. This is the first substantial increase in activity in these banks this year!

Whereas the increase in loan volume was registered in all categories of loans, of particular note was an increase in Real Estate loans of $125 billion. And, the increase was distributed across residential mortgages, $80 billion, commercial real estate loans, $29 billion, and home equity loans, $16 billion. Business loans and consumer loans lagged these totals, but increased by $12 billion and $10 billion, respectively.

The bottom line:

Big banks, in general, seem to be doing very well;

Small- and medium-sized banks, in general, are not doing so good.

This presents quite a dilemma for the Federal Reserve. The bailouts of the big banks have seemingly worked. The big banks were saved from the systemic risk that existed within the financial system (yes, Mr. Goldman Sachs, you too would have failed if we had done nothing—Tim Geithner) and are now doing quite well. The Fed’s policy of keeping short term interest rates close to zero seems to be lining the coffers of these banks in record amounts.

The small- and medium-sized banks are another issue. These organizations, on average, do not seem to be making profits yet. Their loan losses really seem to be piling up and more is going to be asked of them in terms of reserves in anticipation of further losses. External capital does not seem to be readily available to them. And, they have more than 25% of their assets in cash and securities to help them through this period and to be able to pay off their own debt as it matures.

The Federal Reserve must take the condition of these smaller banks into consideration when considering a way to “exit” from its bloated balance sheet. Too quick of an exit could just exacerbate a situation that is already taxing the resources of these institutions.