Recent Monetary Policy and the Growth of the M1 Money Stock

Since the end of June 2011, excess reserves held by commercial banks have declined by about $107 billion. (Remember in August 2008 when excess reserves in the banking system totaled only $2.0 billion…for the whole banking system!) For the two-week period ending November 30, 2011, excess reserves averaged almost $1.6 trillion.

Reserves balances held at Federal Reserve banks dropped by about $110 billion over the same period of time. On December 7, 2011, reserve balances were slightly under $1.6 trillion.

Excess reserves held by the banking system and reserve balances at the Federal Reserve tend to move in the same direction and in about the same magnitude.  The reason for focusing on reserve balances held at Federal Reserve banks is that this number comes from the Fed’s balance sheet and can be related the movements of line items that appear on the balance sheet.

This decline in reserve balances has not been overtly driven by Federal Reserve actions.  In fact, three factors have dominated this decline, and each of the three is independent of what the Federal Reserve might be overtly doing. 

The first two factors relate to components of the Federal Reserve’s portfolio of securities.  After the Fed’s holdings of U. S. Treasury securities, the largest part of the portfolio is made up of mortgage-backed securities.  From the end of June through the current banking week, the amount of mortgage-backed securities on the Fed’s balance sheet dropped by $82 billion and represented maturing securities. 

The Fed’s holdings of Federal Agency securities also feel by almost $11 billion during this same time period again from the run-off of maturing issues. 

The third factor that helped to decrease reserve balances was a $31 billion increase in currency in circulation outside the banking system.  That is, when currency is drawn out of the banks and moves into the hands of individuals, families, and businesses, bank reserves go down…unless these outflows are offset by other actions of the Federal Reserve. 

Just these three factors alone resulted in a $124 billion reduction in bank reserves.  Some open market operations as well as other operating factors offset this decline, but the net result, as mentioned above, was that overall excess reserves in the banking system decline by more about $110 billion over this time period.

While these excess reserves were declining, however, we observed during the same time period, a sizeable change in the speed at which the money stock was growing.  For example, in June, the year-over-year rate of growth of the M1 measure of the money stock was about 6 percent.  In July, the rate of growth increased to 16 percent, in August it was slightly more than 20 percent where it has stayed. 

The M2 measure of the money stock did not show such dramatic increases, since the M1 measure is a subset of the larger total, but it, too, increased during this time period.  In June, the year-over-year rate of growth of the M1 measure was about 6 percent.  In July the growth rate of this measure rose to 8 percent and then jumped to 10 percent in August where it has remained. 

In July and August, the banking system experienced huge gains in demand deposits while in June, July, and August savings deposits at depository institutions rose dramatically. 

These movements along with the continued strong demand for currency in circulation can still be used as evidence that the economy remains very weak.  The $31 billion increase of currency in circulation mentioned above has resulted in the currency component of the money stock measure showing a year-over-year rate of growth by the end of October of almost 9 percent, which is a very high figure historically.  

The movements taking place in the money stock figures point to the weak economy in two ways.  First, with people under-employed, with people trying to stay away from debt, and with businesses trying to build up large stashes of cash, the demand for currency and for transaction balances at financial institutions rises.  Weak economies cause economic units to keep more of their wealth in a form that is readily accessible and spendable.

The second piece of evidence, however, is the extremely low interest rates associated with the weak economy.  With interest rate so low, it just does not pay for people to keep funds in interest-bearing accounts. Over the past five months, savings deposits at financial institutions have dropped by almost $75 billion and funds kept in institutional money funds have dropped by $160 billion over the same time period.  A large portion of these funds has apparently gone into currency and transaction balances.   

People are still getting out of short-term assets and placing their funds, more and more, in transactions-type accounts.  This is a sign of the weak economy and not of economic growth or a successful monetary policy. 

This is “debt deflation” type of behavior. (http://seekingalpha.com/article/307261-debt-deflation-is-it-a-possibility) It is a type of behavior that the Federal Reserve has not yet been able to over come. And, having the Fed toss more “stuff” against the wall does not seem to be the policy to turn things around.

Federal Reserve officials keep talking about up the fact that they have not run out of things that they can do to continue to try and stimulate the economy.  Unfortunately, it seems to me that fewer and fewer people are listening to their pleading. 

With a banking system that is still much weaker than the authorities are willing to talk about; with a consumer sector and business sector that, for the most part, are still trying to reduce their debt load; and with a public sector that is sorely out-of-balance and doesn’t seem to know where it wants to go; people are confused and uncertain about their future and about what to do.  

In this kind of environment, people want to hold onto what they have and want to avoid as much risk as they can.  They don’t want to borrow if they don’t have to and they want their assets to be as liquid as possible.

This is what the Federal Reserve is facing. 

The Number of Banks in US Banking System Continues to Decline

There were 40 fewer banks at the end of the second quarter than there were at the end of the first quarter according to data just released by the FDIC.  On June 30, 2011, there were 117 fewer banks in the banking system than at December 31, 2010.

The commercial banking system continues to shrink.

The good news?

The number of institutions on the FDIC's "Problem List" fell for the first time in 15 quarters. The number of "problem" institutions declined from 888 to 865. This is the first time since the third quarter of 2006 that the number of "problem" banks fell.

The FDIC closed only 20 banks in the third quarter of 2011.  The average number of FDIC closings per week for the year 2. 

So, the pace at which the banking system is declining appears to be slowing. 

The smaller banks continue to bear the burden of the decline.  Since the end of 2010, about 3 percent of the banks with assets of less than $100 million have fallen out of the banking system.  The total number of these banks that dropped out of the banking system was 64.

Note that these smaller banks makes up only about 1 percent of the total assets in the banking system.

The number of banks with assets between $100 million and $1 billion declined by 61 banks, but this represented only about 2 percent of the number of banks in this category.

Note that this category of bank makes up only about 8 percent of the total assets of the banking system.

The largest banks, those with assets of more than $1, actually increased by 8 in the first half of 2011.  Note that these banks make up 91 percent of the total assets in the banking system.

Remember, from the Federal Reserve statistics, the largest 25 commercial banks in the United States make up about 60 percent of the total banking assets in the country. 

The vast majority of the banks on the FDIC’s list of problem banks fall in the less than $100 million in asset class.  The middle class of banks ranked by asset size make up the next largest portion of the problem list. 

So, it seems as if we need to say good-bye to the smallest banks and farewell to many of those in the middle category of banks.  Even if these smaller institutions are not closed, they will be acquired by the larger banks and so the average size of bank in the United States will continue to rise.

My forecast for the past two years is that the number of banks in the banking system will drop to under 4,000 over the next four-to-five years.  Not only will this decline occur due to the weeding out of the problem banks, but the smaller banks will just not be able to compete in the new world of banking that is so dependent upon the new information technology spreading throughout the financial world. 

And, the larger banks?

Again, I see that the largest twenty-five domestically chartered banks in the United States will control close to 70 percent of the total assets in the banking system over the next four-to-five years.  Foreign-related financial institutions will move up to the 10- to 15-percent range. 

So, the 3,950 or so smaller banks will have only 15- to 20-percent of the total assets in the banking system.  This will mean that we will still have a lot of smaller banks around…or, my estimate that there will still be around 4,000 banks in the banking system is optimistic.

The banking system in the United States is changing.  We are not a country based on agriculture that needs a lot of local banks.  That went out with the 1930s.  We are not a country anymore that is based on manufacturing that needs a lot of sizeable regional banks.  That went out with the 1980s.  We are a country that is in the midst of the information age and the predominant financial institution in such an age will be large and will have a sizeable international presence.   

So, the decline in the number of banks in existence is not surprising.  The fact that the decline will continue is also not surprising.  And, a continuing decline will take place even if the economy picks up strength. 

Stocks Fall After Bernanke Testimony

“Bernanke calls the outlook 'unusually uncertain" and notes the central bank is prepared to take additional action if needed. His economic outlook sees lower than expected inflation and at best a slow pace of falling unemployment levels. He notes financial conditions are hindering growth and expects interest rates to stay low for ‘extended period.’ At the same time, he says the Fed is continuing to think of ways to shrink its portfolio, and any asset sales will come gradually. Bernanke's comments to Congress are largely as expected, but some may be a bit taken aback by his comments on shrinking the balance sheet, which doesn't suggest much central bank appetite to provide additional stimulus to a troubled economy. Stocks are taking it on the chin while the two-year Treasury yield is hitting yet another record low. The dollar is holding pretty steady.” As reported by the on-line Wall Street Journal.

The markets are looking for someone to pull off some magic. Maybe we can get Nicholas Cage from “The Sorcerer’s Apprentice” to come do something special. Or, maybe the cry is for an alchemist, someone who can change the real world into something it isn’t.

One of the fundamental principles of economics, a principle of the real world, is that economic variables that are nominal in value cannot change economic variables that are real in value. Throwing more money (a nominal variable) into the economy will not reduce unemployment (a real variable). But, maybe an alchemist could do this.

Furthermore, there are some real structural problems that exist in the economy, the result of the past fifty years of inflationary monetary and fiscal policies. These problems are not going to be chased away by “Helicopter” Ben.

The first of these problems has to do with the labor markets and the current structural dislocations that labor is now facing. I wrote about this yesterday. See http://seekingalpha.com/article/215391-long-term-joblessness-and-u-s-economic-malaise.

The second has to do with the banking industry and the credit problems that still exist for many, many commercial banks. See http://seekingalpha.com/article/215058-grasping-at-straws-in-the-banking-data.

Third, the private sector of the economy is still heavily in debt. Credit card debt remains excessively high and the housing market continues to drag along the bottom. Foreclosures for the year are expected to reach 1.0 million and personal bankruptcies are still at near-term highs. Small- and medium-sized businesses continue to face financial difficulties due to having too much leverage on their balance sheet and commercial real estate is expected to remain a problem well into next year.

Commercial banks have over $1.0 trillion in excess reserves. Is their behavior going to change if excess reserves in the banking system rose to $2.0 billion?

One criticism that has been leveled at economists is that they have built their “science” to resemble classical physics with too much emphasis upon concepts like “equilibrium”. Over the past fifty years or so, one could argue that economists believed that they could use the models they developed to change the world from what it is to what they would like it to be. They assumed that they were alchemists.

In some situations there is only so much humans can do. They cannot “wave their wands” and create something that isn’t there. Reinhold Niebuhr is quoted as saying: “God grant me the serenity to accept the things I cannot change, the courage to change the things I can, and the wisdom to know the difference. “

I am not, by nature a pessimist, nor am I a defeatist. There are things we can do. However, continued aggressive monetary and fiscal policies may not be appropriate at this time. In fact, I have argued that the continued use of aggressive monetary and fiscal policies over the past fifty years has actually created the problems we are now facing. (See http://seekingalpha.com/article/214449-this-liquidity-trap-is-the-real-deal. Maybe the government needs to try other means of relieving pain and helping people to transition to a new world.

The advancement of human knowledge requires us to learn what we can change and what we cannot change. It was an advancement in human knowledge when people learned that you cannot change a common substance into gold. Then people began to find out what they could really do within the real world when they worked with nature and didn’t work against the way things are.

Maybe Bernanke and the central banks realize that there is only so far they can go. The financial crisis of 2008-2009 was minimized by the Fed’s “throw everything you can against the wall and sees what sticks” policy. Here the Fed was doing something it could do.

Now there is some form of “liquidity trap” that prevents the actions of the Fed from working through the banking system. We are in a “pushing on a string” environment. Maybe the Fed realizes that additional efforts at this time would just be trying to make gold out of a common substance.

Maybe the financial markets should realize that the Fed is not going to come up with some magic wand that will sweep away the current economic and financial problems.

Are Smaller Banks a Good Investment?

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

Who do I consider to be the big banks?

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

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

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

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

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

Does this make sense?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Commercial Banking: Still Hanging On

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

And, how is this showing up?

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

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

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

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

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

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

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

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

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

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

The Changing Banking System

I remember when there were more than 14,000 banks in the United States. I also remember when there were 12,000 banks in the banking system. Even in those days, the financial industry only accounted for no more than about one-sixth of total domestic profits in America.

Now there are about 8,000 banks in the United States and about one in eight of these banks is either on the problem bank list of the FDIC or in rather serious trouble. The FDIC is closing three to four banks a week and it is expected to continue on this pace for another twelve to eighteen months.

The biggest banks in the banking system are doing well, profit wise. The reported earnings this week of JPMorgan Chase, Goldman Sachs, Morgan Stanley, Bank of America, Citigroup, and so on just re-confirmed the recovery of these giant institutions. Of course it is not the banking side of the business that is producing these results, although their loan problems seem to be diminishing. It is the trading side of the business that is creating such significant gains subsidized by the Federal Reserve zero interest rate policy. This is the “quiet” bailout of these banks because it does not require Treasury funds to support the effort and it helps bank assets improve so that insolvency becomes less and less of a problem.

Furthermore, regional banks appear to be recovering. PNC and BB&T have been doing well, but those lagging behind, Fifth Third Bancorp, KeyCorp, SunTrust Banks, and Huntington Bancshares all seem to be showing improvements which respect to their problem loans. PNC and BB&T actually reported profits for the first quarter, $671 million for PNC and $194 million for BB&T. So, the improvements continue down the supply chain (http://online.wsj.com/article/SB20001424052748703876404575200240959419542.html#mod=todays_us_money_and_investing.)
We are still waiting for the small- to medium-sized banks to start perking up. But, this is where more of the problem or troubled banks lie and where most of the bank closures or acquisitions are going to be.

This fact points to one of the major changes taking place in the banking system. We are going through another period where the number of banks in the banking system is declining. I would not be surprised at all if the number of banks dropped to the 5,000 to 6,000 range over the next few years.

This movement will continue the consolidation of the banking industry in the United States. Right now, $2 out of every $3 in domestic banking assets resides in the largest 25 banks in the country. These are the huge banks mentioned above and the large regional banks mentioned above.

How high might this concentration go? I believe that regardless of what Congress does with respect to financial reform and trying to limit the size of banks that the total amount of domestic assets residing in the largest 25 banks in the country will go to about $4 out of every $5 in the relatively near future. This means that there will be at least 5,000 banks competing for that other $1!

Another change that is taking place in the United States banking system is the presence of more and more foreign banks. This seems to be a perfect time for foreign owned banks to pick up acquisitions in the United States and not only gain size but also gain presence in different regional markets. In this respect, note the article “Foreign Firms Scoop Up Failed U. S. Banks” in the Wall Street Journal, http://online.wsj.com/article/SB10001424052748704830404575200134085458128.html#mod=todays_us_money_and_investing. Canadian banks are especially taking advantage of the banking situation in the United States, but banks in Japan and other countries are seizing the opportunity as well.

In March, foreign-related institutions controlled over 11% of the assets in the United States banking system. This is up substantially from thirty years ago and is expected to climb further in the near future. My guess is that this number will be in the 15% to 20% range over the next five years or so. And, these assets will not be owned by small- or medium-sized financial organizations.

This is the problem now faced by President Obama and the Congress in terms of financial reform. I just don’t see these trends reversing themselves. And, as banks get bigger they will also be controlling more and more of the banking assets in the United States. And, as the banks get bigger they will continue to move into more and more areas of the financial market and they will continue to create more and more financial innovations.

And, if they are not done in the United States they will be done somewhere else in the world for commercial banking is, in fact, worldwide and not just the playing field of Americans. Big foreign banks are becoming a bigger part of the United States banking scene just as big United States banks are becoming a bigger part of the banking scene in other countries.

The difficulty in writing regulations that try to control what these banks can do is, in the words of economists Oliver Hart of Harvard and Luigi Zingales of the University of Chicago, “doomed to fail because such regulations are extremely easy to bypass. It takes no time for a clever financier to design a contract that gets around most restrictions.” Finance is just information and information can be restructured in almost any way that someone wants it to be structured.

The evolution of the financial system is going to continue to be fought by those constrained to the old Keynesian fundamentalism. The current financial environment has been created by fifty years of government policy conforming to a dogma that considers an inflationary bias to the economy an necessary pre-requisite for sustaining high levels of economic growth and low levels of unemployment.

Well, this inflationary environment has fostered the undisciplined expansion of credit, the excessive leveraging of financial capital, and the creation of more and more financial innovation to underwrite both the expansion of the debt and the aggressive financial leveraging. It has also resulted in the relative growth of the financial industry.

Many of these same commentators have remarked about how the financial sector has grown relative to the rest of the economy. For example, Paul Krugman in “Don’t Cry for Wall Street”, has written: “In the years leading up to the 2008 crisis, the financial industry accounted for a third of total domestic profits — about twice its share two decades earlier.” He then makes the value judgment that “the fact is that we’ve been devoting far too large a share of our wealth, far too much of the nation’s talent, to the business of devising and peddling complex financial schemes — schemes that have a tendency to blow up the economy. Ending this state of affairs will hurt the financial industry. So?” (See http://www.nytimes.com/2010/04/23/opinion/23krugman.html?hp.)

Well, this is the financial industry that a government following the Keynesian economic philosophy has created. Two final comments: first, care needs to be taken in creating economic policies because the long run effect of the policies may not be what you want even though the short run effects are what you want; and second, once the size and structure of an industry has been created, it does not go away until the industry becomes technologically obsolete. The financial industry is thriving using information technology, a field that is just in its infancy. Finance and information technology have a long way to go.

Federal Reserve Exit Watch: Part 9

The operating statement of the Federal Reserve is getting downright boring these days. Thank goodness! It brings back memories of the good old days when nobody really cared much about the Fed’s balance sheet or what the Fed was really doing operationally.

I remember calling a friend of mine at the Fed in February 2008. I had a question. There was a new thing called “Central Bank Liquidity Swaps” and I was trying to locate where it was on the Fed’s H.4.1 release, the “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks.” At that time, because it was brand new, it didn’t have a separate line item to indicate what the Fed was doing with currency swaps with other central banks. I presumed that the numbers were added into the account “Other Federal Reserve Assets” which had changed substantially in recent weeks and was, formerly, just a miscellaneous collection of a number of different unimportant accounts.

After confirming that the “Other Federal Reserve Assets” contained the information on “Central Bank Liquidity Swaps”, my friend asked me why I was interested in writing about this in my new blog. “Nobody is interested in the Federal Reserve statement. You are just wasting your time!” he said.

Obviously, over the next 24 months or so, a lot of people got interested in the Federal Reserve statement. If we want to talk about financial innovation in the last twenty or thirty years, what happened inside the Fed during this period of time certainly represents some of most important “financial innovation” that took place. To not watch what the Fed was doing with its balance sheet was to miss a large part of the show.

Now, that show is coming to a dull close. Again, we can be very thankful for this. In the banking sector, “DULL IS GOOD!”

First, the Fed had supplied approximated $2.349 trillion in funds to the commercial banking system on March 31, 2010. I estimate that at most $200 billion of these funds are related to the special programs that were created over the past two and one-half years, only about 8.5%. These $200 billion in assets will slowly trickle off the Fed’s statement and will cause very little impact, if any, on the banking system or on financial markets. Good riddance!

Of course, the other $2.1 trillion in funds that the Fed has supplied to the banking system still looms over the financial markets and the economy because almost $1.1 trillion of those funds are residing in commercial bank reserve balances at Federal Reserve banks. In other words, the commercial banking system possesses about $1.1 trillion in excess reserves.

But, the situation is “boring” now because on March 31, 2010, the securities portfolio of the Federal Reserve amounted to slightly more than $2.0 trillion: $777 billion in U. S. Treasury securities; $169 billion in Federal Agency debt securities; and $1,069 billion in Mortgage-backed securities. The removal of funds from the banking system in the Federal Reserve exit strategy, we are told, will come from selling these securities through outright sales or, initially, through repurchase agreements. This is where most of the action will be in the future.

There is another vehicle that the Federal Reserve has cooked up with the U. S. Treasury Department to drain some reserves from the banking system using an account of the Treasury’s at the Fed. This is the “U. S. Treasury, supplementary financing account” and it appears as a liability of the Federal Reserve. (See my post of February which describes this facility: http://seekingalpha.com/article/190404-the-treasury-s-latest-maneuver-with-the-fed.) An increase in this account absorbs funds from the banking system so it can be used to remove reserves along with the Fed operations in its securities portfolio.

At the end of 2009, this supplementary financing account was at $5.0 billion. The Treasury Department had to wait until Congress raised the United States debt limit before it could again rebuild this account. The account has risen by $120 billion since December 30, 2009 and by $100 billion since March 3, 2010. This has helped to keep reserve balances at the Fed relatively constant since the end of the year while the Fed was, at the same time, supplying reserves to the financial markets during this time by buying mortgage-backed securities.

So, in the last 13-week period, the financial markets were relatively calm, the commercial banking system was peaceful, and the Fed did practically nothing except buy $160 billion more mortgage backed securities. The question is, “Is this the calm before the storm?”

No one knows how the “Great Undoing” is going to proceed. The Fed has stopped buying mortgage-backed securities as it promised it would do. There has been some reaction in the financial markets (See “Mortgage Risk Premiums Widen”: http://online.wsj.com/article/SB20001424052702304539404575157612509328610.html#mod=todays_us_money_and_investing.) Mortgage rates have also risen. We are told that “A lot of people are observing what’s going to happen now that the Fed is actually out.”

Now the waiting begins. The Fed has confirmed that it will continue to keep its target interest rate range at current levels for the near term. There are still many uncertainties in the economy that are keeping the Fed from removing the reserves from the banking system and raising its target interest rate range. One of these, of course, is the state of the economy. Economic growth continues to remain anemic, although it seems to be picking up, and the unemployment rate continues to hover around 10.0%.

Furthermore, the health of the banking system, itself, remains questionable as about one in eight banks remain on the problem bank list or near to it. Bankruptcies continue to rise (http://www.nytimes.com/2010/04/02/business/economy/02bankruptcy.html?ref=business) as do foreclosures on homes. We are still waiting to see how the commercial real estate industry works through the next 12 months or so. The Federal Reserve does not want to remove reserves from the banking system if the banking system “wants” to keep those reserves to protect itself during the continuing financial workout period.

The Fed is now as ready as it ever will be to execute its “Great Undoing”. We continue to need to watch the Fed’s balance sheet to observe what the Fed is actually doing with its portfolio of securities and how the Treasury Department is contributing to the removal of reserves through the manipulation of its supplementary financing account.

As with the banking system itself, the thing to hope over the next year or so is for in the actual execution of the Fed’s exit strategy to be accomplished in an orderly fashion. Keep your fingers crossed!

Federal Reserve Exit Watch: Part 8

Looking at the Federal Reserve statistics these days is rather boring. As has been reported over the past month or two, the Fed has gotten its balance sheet in position for the “great undoing.” And, now it is just waiting.

One can divide the Fed’s balance sheet into three components: the “regular” portion which is roughly equivalent to the asset side of the balance sheet of the Fed in the “good old days”; the portion of the balance sheet that consists of line items related to the “new” facilities created to combat the financial collapse; and the “liability” side of the balance sheet which includes Treasury deposits and reverse repos, the account the Fed has stated it will use in the “undoing” of the excess reserves it has injected into the banking system.

The “regular” portion of the Fed’s statement now represents over 90% of the assets of the central bank. Almost $2.0 trillion of these assets are in the form of securities that the Fed has purchased on the open market and holds outright. The only real movement here is in the Fed’s holding of mortgage-backed securities which, on March 3, 2010, amounted to slightly more than $1.0 trillion. The Fed has stated that this account will reach $1.25 trillion by the end of March.

The Federal Reserve has added, net, $175 billion of the mortgage-backed securities to its portfolio over the last 13-week period, roughly $70 billion in the last four weeks.

In terms of the “new” facilities, the Fed is letting these items run off as the assets run off, are written off, or are sold. Over the last 13 weeks, since December 2, 2009, these accounts have declined by slightly more than $100 billion. Over the past month, since February 4, 2010, they have declined by $30 billion.

Overall, therefore, the Federal Reserve has supplied roughly $76 billion to the building of reserve funds over the last 13 weeks and slightly more than $30 billion over the last 4 weeks. Rather a non-event if you ask me.

In terms of factors absorbing reserve funds, the interesting item here is the Supplementary Financing Account of the United States Treasury. I wrote about this account on February 24, 2010 for it seems to be something that the Fed/Treasury is also planning to use during the “undoing”. For more on this see my blog post: http://seekingalpha.com/article/190404-the-treasury-s-latest-maneuver-with-the-fed.

What has happened in this account is that it has been increasing. It reached a low early this year at $5.0 billion, as the Congress had to approve an increase in the federal debt limit. Since February 4, 2010 this account has increased by $20.0 billion. The Federal Reserve announced that an agreement had been reached with the Treasury Department that the Fed will borrow $200 billion from the Treasury and leave the cash on deposit at the central bank. As explained in my post, this borrowing will be used by the Fed to help it “undo” excess reserves in the banking system. It seems as if the Fed is starting to build up this facility slowly so as not to be disruptive to the banking system.

If we combine all the factors supplying reserve funds to the banking system and factors absorbing funds from the banking system we find that commercial bank’s Reserve Balances with Federal Reserve Banks increased by roughly $70 billion in the last four weeks and over the last 13 weeks: thus, very little changed in the banking system over the last quarter of a year.

If we look at the statistics from the banking system itself, we see that excess reserves in the banking system rose by about $110 billion.

What the Fed did, as it has for an extended period of time now, went directly into the excess reserves of the banking system. Commercial banks, as a whole, are just sitting on their hands and doing nothing. This allows the Fed to do all its repositioning in order to prepare for the “great undoing” without throwing any more uncertainty into financial markets.

The Federal Reserve is still “sitting on the fence”. Its dilemma is that the banking system still remains extremely week…except, of course, for the big banks. For more on this see two of my recent posts: “The Struggles Continue for Commercial Banks”, http://seekingalpha.com/article/190191-the-struggles-continue-for-commercial-banks, and, “The Banking System Continues to Shrink”, http://seekingalpha.com/article/188566-the-banking-system-continues-to-shrink. The Fed cannot move too fast to remove excess reserves from the banking system for fear that this “undoing” may result in many more bank failures among the small- to medium-sized banks.

Of course, the economy remains weak and the Fed has used this excuse for not removing reserves from the banking system and raising short-term interest rates. This may be a cover for their real concern over the systemic weakness of the small- and medium-sized banks in the United States.

On the other side there is the continuing fear over the possibility that sooner or later the excess reserves in the banking system will turn into bank loans which will result in an expansion of the money stock measures which will result in a worsening of inflation. With over $1.1 trillion in excess reserves in a banking system that used to carry less than $100 billion in excess reserves there is substantial doubt that the Fed can smoothly remove all of these reserves thereby preventing possible inflation or even hyperinflation. Nothing like this has ever been experienced in history before.

So, we sit and wait.

The good news is that things within the banking system seem quiet now. The FDIC continues to close banks without major disruptions to banking markets or local economies. The focus of financial markets seems to be on Greece, Spain, Italy, the Euro, and California, New York and other political entities. That is good for the banking system!

Some have pointed to a potential problem arising from the sale of assets recently conducted by the FDIC. The argument is that now that these assets have a price, will other banks have to “mark-to-market” similar assets that they carry on their balance sheet? And, if they have to mark these assets to market, will this speed up the number of banks actually failing or force banks that seem to be doing OK into insolvency?

In the circumstances we now find ourselves, boring is good! Let’s hope it stays boring. Or hope that the situation becomes even more boring.

The Banking System Continues to Shrink

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

American commercial banks are not lending…period!

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

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

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

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

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

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

A Look At The Monetary Aggregates

The growth of the monetary aggregates has slowed significantly in recent months. This, of course, does not mean that the significant concerns over the $1.0 trillion in excess reserves in the banking system have evaporated. By no means!

Looking at the monetary aggregates does provide us with vital information about what economic units are doing with their assets. We took a look at this in an earlier post last November: http://seekingalpha.com/article/175766-how-people-are-using-their-money-and-what-it-says-about-the-economy. At that earlier time, it was obvious that people were moving their assets into transaction accounts and shorter maturity deposits. Also, people were moving money from thrift institutions into commercial banks.

This general movement of wealth can be called “bearish”. That is, when people lack confidence in the economy and in the future, they move into cash and other very liquid assets.

The December year-over-year rate of increase of the currency held outside the banking system stands at 5.7%. This is right in line with the growth rate of M1, the narrow measure of the money stock, which was 5.9% in December.

These growth rates are the lowest to be achieved in 2009. As I shall argue, this is not a sign that “bearishness” is over, just that it lessened throughout the year.

The August year-over-year growth rate for currency was 10.5% and for October 8.3%. The similar measures for the M1 measure of the money stock were 18.5% and 13.4%, respectively. Thus, the move into these assets have slowed, measurably.

There is still strong information that economic units are moving funds from time and savings accounts into transaction accounts. The December year-over-year growth rate of non-M1 accounts, primarily time and savings deposits, was 2.4%, substantially below the growth rate of Demand Deposits and other Checkable Deposits which stood at 6.3%.

The movement here also indicates that the movement from thrift institutions to commercial banks remained strong. For example, the year-over-year rate of growth of Thrift Deposits was 1.7% and this included an increase of Checkable Deposits at thrift institutions of 13.1%. The thrift industry is still really suffering.

Add to this the fact that the 1.7% figure includes deposits at Credit Unions, which are rising significantly, strengthens the argument that the traditional thrift industry continues to suffer badly!

Additional evidence of the move into very liquid assets is the fact that the amount of money placed in Retail Money Funds dropped almost 26%, year-over-year, and the money placed in Institutional Money Funds fell by 8.0%, year-over-year.

People continue to be afraid of the future, and, as a consequence they remain very bearish in terms of how they are managing their assets.

This leads to the conclusion that the basic positive movements in financial markets, in the stock market and in the bond market, almost all come from institutional trading. And, this “good” performance is coming from the interest rate subsidy that the Federal Reserve is providing to the banking system and the financial markets.

The increase in transaction accounts in the banking system has meant that the required reserves of the banking system have increased. The December year-over-year rate of increase of required reserves in the banking system was 18.5%.

To cover this, the Federal Reserve, continuing to err on the side of providing too many reserves, increased the monetary base by 22.0% over the same period of time. As a result, excess reserves rose by 40%.

The banking system still tells us a lot about what is happening within the economy. It tells us what the banks, themselves, are doing. It tells us how people are allocating their assets. It provides us with a gauge about the bullishness or bearishness of economic units. It also gives us some information on how the different sectors of the banking industry, big banks, small- and medium-sized banks, and thrift institutions are doing.

The scorecard:

• People are still moving their money from savings accounts to transaction accounts;
• Commercial banks, in general, are not lending;
• Economic units are, by-and-large, still very bearish;
• Big banks are doing very, very well;
• Small- and medium-sized banks are still on the edge;
• And, thrift institutions are really suffering.

One doesn’t see much of a recovery captured in these results.

Banking Sector Still Remains Silent

There is good news and bad news from the banking sector. The good news is that all is quiet. The bad news is that all is quiet.

In terms of the goods news, “quiet is good” because there have been no new “discoveries” of bad loans or bad assets that will shock the financial system. We continue to hope for silence here even with the continued growth in the unemployed, in bankruptcies, in delinquencies, and in loans coming due that need to be re-priced or re-financed.

In terms of the bad news, there is still no life in bank lending. If we are going to see a pick-up in the economy and a return to growth the banking sector is going to have to start lending again, especially in the commercial sector. Commercial and industrial loans were down by 3.3%, year-over-year in June, and in the last five weeks, all in July, these loans have fallen by another $24 billion.

Real estate loans peaked in May 2009 and have declined ever since, dropping approximately $60 billion through the end of July. Even the amount of home equity loans has declined steadily since reaching a peak in May. Consumer loans continue to drop, with credit card debt falling for the fifth consecutive month.

Total bank assets are still up on a year-over-year basis by 7.5%, but the main balance sheet increases are in cash assets, primarily deposit balances at Federal Reserve Banks, and in Treasury and agency securities.

Banks are still not doing any lending to speak of and are staying very, very liquid.

On the liability side of commercial bank’s balance sheets, demand deposits are still rising at a very rapid pace, about 38% on a year-over-year basis. Other checkable deposits at commercial banks are rising at a relatively rapid pace, 19.3%, but a surprising bit of information is that other checkable deposits at thrift institutions have only increased by a modest amount, by 2.9%, year-over-year.

Checking into the thrift institution situation a little further we find that savings deposits at thrift institutions have actually declined year-over-year at a 7.9% rate and small-denomination time deposits at thrift institutions have fallen at a 14.3% rate over the same time period. These balances at commercial banks have increased at a 16.3% rate and a 15.3% rate respectively.

Two shifts seem to be taking place in depository institutions. First, there seems to be a major movement of funds from thrift institutions to commercial banks. Second, individuals are holding more and more of their funds at commercial banks in demand or other checking accounts relative to time and savings accounts. One additional note to this: retail money funds have dropped by about 11.6% on a year-over-year basis indicating another shift taking place from non-banks to commercial banks.

Another trend continues to hold and that is in terms of currency holdings outside of the banking system. Year-over-year, the currency component of the money stock continues to rise in excess of 10%. Like the banks, the public wants to remain as liquid as possible in order to be able to meet the contingencies people experience in uncertain times.

This movement of assets is reflected in the aggregate money stock figures. The Fed publishes money stock growth figures using 13-week averages. On a year-over-year basis using the thirteen weeks ending July 27, 2009, the narrow measure of the money stock, M1, has increased at a 17.0% annual rate whereas the broad measure of the money stock, M2, has increased at an 8.7% annual rate. It is obvious that the growth rate of both measures is dominated by the huge annual rate of increase in demand deposits as people have re-allocated their funds from time and savings accounts to checkable deposits in commercial banks.

This shift is even more obvious if one looks at the relative rates of growth over the past three months. M1 growth is 15.4% while M2 growth is 3.1%, indicating that much of the re-allocation of funds has come in the past three months.

In terms of the Fed’s assets, there continues to be a runoff of dealers using the Commercial Paper funding facility indicating some easing of liquidity in the commercial paper market. This decline was expected to occur as the commercial paper market improved and this is a hopeful sign. Central bank liquidity swaps also continued to decline indicating an additional strengthening of foreign exchange markets around the world, another hopeful sign.

Both of these declines in the Fed’s balance sheet resulted in reserves leaving the banking system. All it means, however, is that excess reserves in the banking system declined. These excess reserves still remain well above $725 billion, while required reserves total around some $65 billion.

As reported before, the banking system seems to be coming out of the big financial bust in typical fashion. This is why the claim that things are quiet in the banking system is a good thing. We can only hope that this peace and quiet will continue.

There will continue to be bank failures. We reached 72 for the year this last week, but there were no surprises in the increase, they had already been identified. One concern arising from the figures presented above is the health of the thrift industry. With funds leaving the thrift industry as reported, what pressure is this putting on thrift institutions in terms of their assets and solvency?

The big question remains: “When are the commercial banks going to start lending to businesses again?” To answer this, we need to keep a close eye on the information coming out of the banking sector. My guess is that banks will not be too quick to start lending to businesses again. There are questions about how brisk the “back-to-school” season will be and there may not be much increase in lending during this time. The next really big test after that will be the holiday season that begins in October and early November. It will be interesting to see how lending activity behaves at this time.

The Fed continues to keep funds going into the capital markets in terms of acquiring Treasury securities and mortgage-backed securities while letting some of the other facilities that were created to support liquidity in different specific areas of the financial markets run off as it was hoped that they would do. As long as the banking sector remains relatively peaceful, this seems to be the way the Fed wants to act. Then as liquidity picks up in the stressed areas of the capital market, the Fed plan is to sell these other securities back to the private sector and reduce the size of its balance sheet.

The good news in the banking sector is that things are relatively quiet. May they stay that way. In my view we will have to wait a while before we see the banks beginning to refuel businesses and the real estate sectors.

The State of the Banking System

There are three preliminary indicators that the banking system is coming along on its way to recovery. First, there is the “letting go” of CIT Group, Inc. The government must feel that it does not need to extend itself to help out this institution given its present troubles. (See my recent post on the CIT situation: http://seekingalpha.com/article/148730-cit-s-debt-issues-show-why-the-economy-won-t-be-picking-up-any-time-soon.) We’ll see if they continue this approach with other troubled institutions as additional situations arise.

Second, there is evidence that the regulators are taking a harder line at Bank of America and Citigroup. Each has its own problems, but the Feds seem to believe that they can step up their demands on these two financial institutions concerning boards, managements, business affairs, and so forth. They would not do this if they believed the system to be too fragile.

Third, I sense the Federal Reserve backing off from the more aggressive stance it took with respect to the bond markets one to two months ago. This is just a feeling that I will be following up on in the near future.

These actions provide some preliminary evidence that we are in the “working out” stage of the credit cycle where time is the biggest factor to contend with. Bailouts are needed to prevent “liquidity” problems when markets might crumble under cumulative selling pressures. But, this is a short run problem.

The “work out” phase of a financial crisis is the period when institutions still have severe credit problems but are not under short term pressures to relieve their balance sheets of “toxic” or “underwater” assets.

This does not mean that there will not be more failures of financial institutions and some of them may be relatively large ones. What it does mean is that the problems that still exist within the financial sector can be handled in a relatively orderly fashion. So, the banks and the regulators can operate within an environment that does not seem “desperate.” Severely troubled still, but not in a state of panic.

Within this scenario, the questions that remain about the banking system relate to earnings. We have seen Goldman Sachs and JPMorgan Chase & Co. post strong gains for the second quarter. However, most of the gains were attributed to trading activities, with secondary help from their underwriting business. These are not good, solid “banking” results. And, these organizations are highly diversified and can post returns from these areas, something that most other banks in the United States cannot do.

Still, the banking system seems to be in the stage of recovery where current cash flows can allow the individual banks to write off more and more of their loans and other assets over time and thereby restore the integrity of their balance sheets. With the results it achieved in trading and underwriting, JPMorgan Chase was able to take large write downs of home equity loans, mortgage defaults, and credit card charge offs while also increasing the amount of funds it set aside to increase its loan loss reserve. This is what other banks will be doing to reduce the burden of bad assets they are now carrying.

Overall, Total Assets in the commercial banking system grew by 8.9% from June 2008 to June 2009. The capital residual (Assets less Liabilities) in the system grew by 7.6% so that the capital asset ratio of the banking system dropped from 10.2% to 10.1%.

In terms of how the banks are attempting to protect themselves, the Cash assets of Commercial Banks in the United States were up 186%, year-over-year, in June 2009, although this rate of increase is down from a year-over-year rate of increase of 236% increase in May 2009.

Total Loans and Leases in the banking system rose just about 1.4%, year-over-year, in June while Commercial and Industrial Loans actually decreased by 3.1%. Commercial banks are just not lending to businesses which continues the trend which began last year. Banks are lending to consumers, up 5.5% year-over-year (primarily on credit cards and other revolving credit plans), and on real estate, up 6.4% year-over-year (the largest jump coming in revolving home equity loans).

The cash assets held in the commercial banking system declined regularly throughout June as the peak in cash assets held was reached in May. Thus, it appears that banks are backing off from taking everything the Federal Reserve has put into the banking system and stashing it away in “cash accounts”. This is confirmed by the aggregate banking data put out by the Federal Reserve which indicates that total reserves in the banking system dropped throughout June 2009 and the excess reserves also fell from peak levels reached in late May.

Thus, it appears that things are working out pretty much as the Fed hoped they would. (See my explanation of what the Fed has been trying to do, http://seekingalpha.com/article/145913-is-treasury-s-tarp-debt-already-monetized-part-ii.) Of course, the game is not over yet!

Bottom line: the banking system is working through its problems. The Federal Reserve and the regulators seem to be backing off a little, allowing the system to adjust over time to its dislocations. There is still room for a surprise, but, the more time passes, the less likely a surprise is likely to occur. In other words, the unknown unknowns have been substantially reduced and the known unknowns are what we are working on.

The banks are not lending except on established credit lines (credit cards and home equity loans) and there appears to be plenty of liquidity in the system as a whole. Whereas the lack of lending slows up the possibility for an economic recovery, it is an essential component of getting the banking system healthy again which is needed if there is to be any chance of a robust economic recovery in our future.

When Will the Banks Start Lending Again?

The Federal Reserve, as we know, has been pumping all kinds of reserves into the banking system. For the banking week ended May 2, 2009, Federal Reserve Bank Credit stood at $2.041 trillion. This is up from $0.894 trillion for the banking week ending September 3, 2008, an increase of $1.147 trillion.

Total reserves in the banking system jumped from $44.1 billion in the month of August 2008 to $881.8 billion in the month of April 2009. This is an increase in total reserves in the banking system of $837.7 billion.

Note that the difference between the amount of credit the Federal Reserve extended to the economy and the increase in total reserves in the banking system is $309 billion, the amount of Federal Reserve credit that ended up in coin and currency outside the banking system.

This massive growth in total bank reserves can be picked up in the year-over-year growth in total reserves as represented in the accompanying chart. Note that the year-over-year rate of growth in total reserve for April 2009 is 1,924%.














The crucial point I want to make here, however, is that in the banking week ending September 3, 2008, Federal Reserve credit stood at $894 billion. The increase in total reserves at ALL commercial banks from August 2008 through April 2009 was $838 billion. In eight months the Federal Reserve added just about the same amount of dollars to commercial bank balance sheets that it had accumulated on its own balance sheet in the 94 years beginning in 1913!

And, what did the commercial banks do with the funds the Federal Reserve forced into the banking system. It sat on them. In the next chart we get a picture of the excess reserves of all commercial banks in the United States. We see the commercial banks are holding $824 billion in excess reserves. That is, in August 2008, the commercial banking system held between $1.0 and $2.0 billion in excess reserves. So, almost all of the increase in total reserves in ALL of the commercial banking system between the first of September 2008 and the end of April 2009 went into excess reserves! There was next to no lending going on in the whole banking system.

What happened to loan growth in the United States banking system? Well, in the fall of 2008 the year-over-year rate of growth in the loans and investments held on the balance sheets of all commercial banks was over 10%. In April 2009, the year-over-year rate of growth in loans and investments held on the balances sheets of all commercial banks was just over 2%. Loans in the commercial banking system increased by a little more than this number but, the decline in the loan series was even greater than what took place in loans AND investments.

The bottom line is that the banking system was putting out next to nothing in loans or in investments in securities. The banking system basically has sat on the reserves that the Federal Reserve has pumped into the economy.

There is only one conclusion that I can draw from the analysis of these data. Commercial banks are so petrified at their condition that they are not putting any money out into the business or financial community!

I don’t care what the stress tests show. Behavior speaks louder than stress tests! Commercial banks aren’t lending because they can’t take the risk that they will put any more bad loans onto their books. At least cash holds its nominal value and is not subject to default risk!

When will banks begin to lend again?

Unfortunately, I don’t like any of the answers I come up with that would account for them lending more in the near term.