Response to "The Future of Banking" Comments

In response to two comments on my recent “Future of Banking” post (http://seekingalpha.com/article/287037-the-future-of-banking-looks-grim-again) I would like to make the following additions.

First, in terms of the number of employees in banks, I truly believe that the existing model of commercial banking is “legacy” and is in the process of changing.  The comment was made, for example, that “Until customers don't want to come into bank branches anymore, you will have to retain that model.”

In the past five years, I don’t believe that I have been in a bank branch in which there were more than three customers (including myself) at any one time.  And the branches are of similar size to the ones in which I was a teller back in the 1960s. 

I remember those days.  On a Saturday morning when the branch opened at 9:00 AM we would have eight tellers working eight tellers windows and lines of 10 to 15 people at each window constantly until 1:00 PM when the branch closed.  The weekdays were not so busy, but there was always a constant flow of customers through the banks.

I do not know exactly what the future of banking is going to be, but I am working on it as I write.  I have studied, written about, helped start up companies and worked with early stage companies in the area of information technology.  I am on the board of a newly formed bank and am in the process of starting up a credit union.  The use of information technology is constantly on my mind with respect to its application to the finance area. 

Everything I know and have experienced indicates that banking and finance is going through a quantum leap and, over the next ten years, will evolve into something we may not recognize as banking and finance, given the models we work with today.

In teaching classes in information science, I suggested two places for the students to look for ideas about what the future would be like.  First, I said, look at what the military is doing.  They must be ahead of everyone else in their ability to keep secrets and to fight wars (kill people).  They must have the most advanced technology.  Second, I said, look at what the young people are doing the kids in the 8 to 14 age bracket.  What is ubiquitous to them will be “standard” in five to eight years. 

If your business does not take these two things into account in your operations then you will probably not be around to enjoy this future.

I know young people that have not been inside a bank or the branch of a bank for at least five years.  I seriously doubt that my grandchildren will see the inside of a bank or the branch of a bank more that just a few times in their life. 

Finance is information…and nothing more.  Hence, how information is stored, processed, and used will dominate the practice of finance. 

I hope I find out what the future of banking is going to be before others do. 

Whatever it will be, it will not be as people intensive as it is now.

The second comment had to do with “mark to market” accounting.  The comment correctly indicates that many bank assets are probably over valued and this fact will come to light in the future indicating that many banks are in worse shape in terms of capital than we presented think they are.

The comment concludes: “I have seen very few people focus on this in what I have read over the past 3 years, yet I think what I have spelled out here is a potentially looming 'largely unrecognized' further problem. “

I agree with this analysis but would add that over the past three years I have constantly argued in my posts  (you can look them up on Seeking Alpha) that the commercial banking industry needs to go to a accounting system that does a better job of “marking “ assets to market.  This, to me, is essential for the finance industry to be “open” and “transparent”.

In terms of my recent post, I just did not have time to get into this issue.  Of course, adding this issues to the other two does not make the future of banking look any rosier.

The Smaller Banks and Rising Interest Rates

The “sure” bet over the past year or so has been that the Federal Reserve would keep short term interest rates as low as they could for a long time.

In fact, the Fed told us they would keep short term interest rates low for “an extended period” of time, guaranteeing speculative bets on interest rates.

Long term interest rates have also been “low” during this time as liquidity splashed over from the shorter end of the financial markets to the longer end.

However, the spread between long term interest rates and short term interest rates have been very, very nice for a lot of investors and certainly, the bank regulators have not been displeased by the interest rate spreads that have been available to investors, particularly commercial banks and other financial intermediaries who have been able to build up profits to strengthen their institutions.

This spread has been nice for profits but this was not exactly all that the Federal Reserve wanted throughout this period of quantitative easing. In fact, the Fed was very clear that one of the main reasons it was engaged in quantitative easing was that by flooding the financial markets with liquidity, longer term assets, which under other circumstances proved to be very illiquid, could be disposed of when the markets were in a much more fluid situation. The banks were supposed to sell off a lot of their long-term or less-liquid long-term securities.

Furthermore, this would ease the pressure of “mark-to-market” accounting on the banks since such sales at prices closer to purchase value would allow the banks to escape the need to write down other, similar assets even though there was no intent on the part of the banks to sell the securities in the near term.

The larger commercial banks in the system took advantage of this interest rate spread in the earlier stages of the recovery to generate healthy profits and get themselves back on the way to greater solvency, with reduced regulatory oversight.

Then, the larger banks moved on to other things, once the regulators backed off and government money was repaid. The biggest banks are not nearly as mismatched as they were two years ago.

In my opinion, the interest rate policy of the Federal Reserve did more to help the biggest banks regain their “mojo” than did any other part of the bailouts. The Fed’s policy was a grand subsidization program carried out under the cover of helping to get the economy moving again.

The smaller banks, however, have not prospered from the quantitative easing. The maturity mis-match has allowed these smaller organizations to counter some of the enormous losses in commercial and residential mortgages they had to absorb.

But, offsetting these loses did not get the smaller banks back to a robust profitability and, since it was the only game in town, did not allow these banks to deleverage their balance sheets in the way that the larger banks did.

It was the “only game in town” because this maturity arbitrage was profitable, whereas the banks had a lot of bad assets to work out, and making new bank loans, in many markets, were either difficult in terms of finding credit-worthy borrowers or were not guaranteed profit-makers.

As we have seen, the smaller commercial banks in the United States have not been lenders over the last two years or so. Since July 2008, the smaller commercial banks have grown in asset size by about 5 percent, but the increases have come in cash assets and securities holdings. Interest rate arbitrage has been more important to them than initiating new loans, especially with so many existing loans to work out.

Total loans and leases at the smaller commercial banks peaked in February 2009, commercial and industrial (business) loans peaked in November 2008. Both of these categories have been on a downward trend ever since.

The smaller banks still suffer and continue to face the close scrutiny of the examiners in terms of their viability.

Thus, we are sitting on the edge of a rise in interest rates, both long- and short-term, and many of the smaller banks have not gotten out from under the cloud of the longer term assets they hold on their balance sheets.

Of course when interest rates begin to rise, short-term interest rates will rise faster than will longer-term rates and spreads will decline. But, with the specter of interest rates rising, selling long term securities will not be as easy as it has been to sell them over the past year or so.

The smaller commercial banks have benefitted over the past two years by the Fed’s policy of quantitative easing in the sense that they have been able to arbitrage long-term and short-term interest rates. It has provided earnings through the maturity mis-match and it has allowed the banks time to work out some of their assets, charging others off in an orderly fashion. But, this has resulted in few new loans.

As a consequence, the prospect for strong earnings in this sector is slim. The question then becomes, “What are the regulators going to do as the asset portfolios of these banks lose market value as interest rates rise?”

The Federal Reserve cannot continue to keep quantitative easing going, underwriting short term interest rates that are near zero! On this see my recent posts, http://seekingalpha.com/article/262788-fed-s-monetary-policy-cannot-be-conducted-in-isolation, and http://seekingalpha.com/article/262429-trichet-delivers-ecb-hikes-its-interest-rate.

Or, can it?

This would allow the smaller banks the opportunity to carry on with their interest rate arbitrage. However, what really needs to change for many of these smaller banks to survive the times is for real estate prices to rise enough so that the banks’ portfolios of residential loans and commercial real estate loans become solvent again.

We probably will get the rise in prices. But, will the rise really help the properties behind the banks’ problem loans?

Banking is Changing: Look Out for the Opportunities

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Still No Life in Banking

Over the last two months I have been hoping that the smaller banks in the United States were starting to lend a little bit again. I was even looking for “Green Shoots”. (See http://seekingalpha.com/article/220685-green-shoots-in-smaller-bank-lending.)

My latest review of the commercial banking data released by the Federal Reserve gives little indication that things are picking up through August. Total assets at the smaller domestically chartered banks in the United States (defined as all domestically chartered commercial banks except the largest 25) grew by a little over $11 billion in the last five weeks. However, the cash assets of these banks rose by slightly more than $8 billion of this total. Only about $1 billion went into bank loans.

The total assets at the 25 largest domestically chartered commercial banks fell by about $26 billion during this time period, but the cash assets held by these banks dropped by even more. Cash assets fell by about $41 billion. What asset class rose? The securities held by these banks rose by almost $23 billion.

At these large banks, Treasury and Agency securities increased by about $210 billion over the last year. These banks can acquire funds at interest rates approaching zero percent and purchase securities with no credit risk and earn several hundred basis points spread on the transaction. And, there is little or no interest rate risk because the Federal Reserve has stated that it will keep short term interest rates extremely low for “an extended time.”

One can see this arbitrage situation setting up over the last year as these large commercial banks have changed the way they have financed their assets relying on less expensive sources of funds and substituting cheaper and cheaper liabilities.

No wonder the large commercial banks have been producing a lot of profits while at the same time building up their loan loss reserves!

Why should commercial banks lend when they have a riskless way to make money?

Business loans? Commercial and Industrial loans are down by more than 12% at all banks, from August 2009 through August 2010. At large commercial banks, however, C&I loans are down by even more, dropping at a 14%, year-over-year rate. In just the last 13 weeks, these loans are down by almost $12 billion which is about one-tenth of all the business loan portfolio in the banking system.

Commercial real estate loans are down by more than $140 billion. Of this drop more than half of the decline was registered at the smaller commercial banks. Of course, this is where people are expecting a lot more trouble over the next twelve months or so.

Surveys have indicated that banks are easing up on lending terms. Well, that may be true, but this is still not resulting in any jump in commercial bank lending.

We are told that businesses and consumers are reluctant to borrow. I believe that this is true. There are two reasons for this. First, many businesses, families, and individuals are still reducing the debt load they had built up over the last decade or more. With the economy so weak, it still represents a substantial risk to go further in debt given the uncertainty about future prospects.

In addition, many of the companies that are better off are accumulating large amounts of cash balances. The play here, I feel, is that mergers and acquisitions will pick up over the next year or so. Analysts are still shaking their heads about all the activity that took place on this front in August. My guess is that companies believe that they can achieve better market share and even have a chance to gain sustainable competitive advantages in their markets by building scale through acquisition of financially “weak” companies as opposed to attempting to expand on their own at this time. Keep the cash so that you can move as quickly as possible when the time is right.

Bottom line: it seems as if very few banks want to extend money to businesses at this time; and very few institutions (except for the federal government) want to put on a lot more debt at this time.

There will be no recovery of any strength without a pickup in commercial bank lending. I have written about this earlier: http://seekingalpha.com/article/218027-no-banks-no-recovery. This is one reason why I am skeptical of the spending and tax-cutting proposals presented by President Obama last week. The economy is in a position where debt positions, both in the financial and non-financial industries have to be worked out and this will take time.

I continue to believe that the Federal Reserve will continue to keep short term interest rates at or near their very low current levels until the commercial banking industry stabilizes. The Fed and the FDIC are doing a good job in helping the smaller banks work through their problems. Still, there are a sizeable number of the smaller banks that are still in serious trouble and asset values are still the problem. As mentioned above, there are anticipated difficulties ahead in the commercial real estate area and some investment portfolios are still substantially under-water.

With all these difficulties, why should these smaller banks, in aggregate be expanding their loan portfolios? The main thrust in the commercial banking sector over the next twelve to eighteen months is still survival and consolidation.

My prediction still remains: over the next five years or so the largest 25 domestically chartered banks in the United States will come to control about 75% of banking assets in America, up from about 67% at the present time.

"Grasping At Straws" in the Banking Data

The commercial banking industry was still contracting through June. Year-over-year, that is from June 2009 to June 2010, total assets in the United States banking sector dropped by a little more than 1.5%, with the assets of large, domestically chartered banks dropping by 3.0% during this time period. The total assets at small, domestically chartered banks rose by slightly more than 1.0%.

Year-over-year, the loans and leases at commercial banks within the United States dropped by 2.5%. The drop at large, domestically chartered banks was 0.2%, at small, domestically chartered banks was about 3.0%, and at foreign-related institutions the drop was 16.0%.

An interesting pattern is showing up in the data, however, and gives us something to look for going forward. The smaller, domestically chartered banks in the United States increased their loan balances a little bit over the four-week period ending in the week of July 7, 2010.

The Federal Reserve System has defined large commercial banks as the largest twenty-five domestically chartered banks in the United States. These banks control about one-third of the banking assets in America, a total of about $6.9 trillion. Small banks are all of the rest of the domestically charted banks in the country and they number slightly more than 8,000 banks.

Over the past four weeks, all loans and leases at the smaller banks rose by almost $3.0 billion. This is the first time in the past 18 months or so that the small banks have posted an increase in total loans and leases. The increase was not large…but, we are looking for any “green shoots” that we can find.

The increase was not “across the board” but Commercial and Industrial (C&I) loans, business loans, rose by slightly more than $2.0 billion and Consumer loans rose by a little more than $6.5 billion. Real Estate loans dropped by $5.5 billion, mostly in the commercial real estate area. It should be noted that both C&I loans and Consumer loans rose for the last 13-week period, although most of the increase came in the last four weeks. For this latter period, Real Estate loans dropped by more than $21.0 billion, again in the commercial area.

We continue to hear that these smaller banks still have lots of problem commercial real estate loans to deal with and may remain reluctant to lend in this area for an extended period of time.

Remember, it is in the smaller banks that most of the problems still exist relating to bank solvency. At the end of March, there were 775 banks on the problem bank list of the FDIC, implying that roughly one out of every eight of these smaller banks were “problems.” Through July 16, the FDIC had closed 91 banks this year, roughly 3.4 banks each and every week. This pace is expected to continue for at least the next 12 months. Later this month the FDIC will release the list of problem banks it has identified as of June 30, 2010. The expectation is that the number of banks on the list will increase above 775!

At the larger commercial, the largest 25 in the country, Loans and Leases continued to decline. In the last 4-week period these large banks experienced a drop of over $16.0 billion in that line item. For the last 13-week period the drop was in excess of $81.0 billion. Declines in the last 13-week period came in all lending areas as C&I loans fell by about $22.0 billion, Real Estate Loans declined by more than $26.0 billion and Consumer Loans dropped by approximately $31.0 billion.

Declines took place in all loan categories at the large commercial banks over the past four weeks, but the drops were not anywhere near as deep as in the previous two months.

Cash assets at the domestically chartered banks finally seem to be falling. Over the past four weeks, cash at large banks dropped by $35.0 billion while the smaller banks saw cash balances decline by a little more than $11.0 billion. Over the past thirteen weeks, cash assets at the larger banks fell by $61.0 billion while they only fell by $6.0 billion at the smaller banks.

This decline in cash assets is consistent with the drop in excess reserves in the banking system over the past several months. (See http://seekingalpha.com/article/214058-federal-reserve-exit-watch-part-12.)

There was an interesting bump in cash assets at foreign-related institutions during this time period. In the past 4-week period, cash asset at foreign-related institutions rose by $16.0 billion; and they rose by $25.0 in the last 13-week period.

Could this jump have anything to do with the “stress tests” being administered to major European commercial banks?

I don’t remember ever having seen an increase like this in foreign-related banks in such a narrow time span.

Business loans at these foreign-related institutions dropped over the past 4-week and 13-week periods while “other” very short-term lending, which could include loans to banking offices not in the United States, experienced a substantial rise.

Could these movements have anything to do with “window-dressing” for the European “stress tests”?

The summary for this month’s review of the state of the banking industry is much the same as in previous months. The two things to keep a watch on are, first, the small increases in business and consumer lending at the small, domestically chartered banks; and second, the drop in cash assets being held in aggregate by all domestically chartered banks in the United States.

The first piece of information raises hopes that the smaller banks are beginning to lend again to businesses, although not on commercial real estate deals, and consumers, again not on real estate. In terms of the latter, the hopes for a recovery in mortgage lending do not seem very promising as some analysts in the real estate industry predict that foreclosures for the year could approach 1.0 million homes. Some analysts are even saying that banks are not foreclosing as rapidly as they could so as to avoid the housing market being too jammed up with foreclosed houses. That is, the banks are “pacing the foreclosures” so that homes can be sold faster. This does not bode well for the future.

The second piece of information raises hopes that commercial banks are feeling more confident about the future and are, therefore, reducing the amount of cash (excess reserves) they hold on their balance sheets. Not only did lending at the smaller banks increase their lending over the last four weeks, the larger banks only experienced modest declines in their loans outstanding.

Many economists have declared that the recession ended in July 2009. So, the economic recovery has been going on for almost twelve months. The major problem with this claim is that the commercial banking system has not been acting like the recession is over. This has also been reflected in the balance sheet of the Federal Reserve System and in the performance of the monetary aggregates. (See my post referenced above for a discussion on these points.)
Thus, we are scratching around trying to find positive signs in the banking statistics. With this report we are grasping at straws. But, we have not even had tiny straws

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!

Wall Street Smarts

After I posted my comment on “Do we Really Need to Break up the Banks?” yesterday (http://seekingalpha.com/article/168514-do-we-really-need-to-break-up-the-banks), I remembered an anecdote from my time in the Finance Department at the Wharton School, University of Pennsylvania. It relates to commercial banks moving from “utilities” to “casinos” in the words of Mervyn King, Governor of the Bank of England.

What brought this incident back to my mind was the recent op-ed piece by Calvin Trillin in the New York Times with the title “Wall Street Smarts.” (See http://www.nytimes.com/2009/10/14/opinion/14trillin.html?scp=2&sq=calvin%20trilin&st=cse.) In this piece Trillin runs into a person who reflects on something a speaker who had just been to a college reunion had shared with him.

“One of the speakers at my 25th reunion said that, according to a survey he had done of those attending, income was now precisely in inverse proportion to academic standing in the class, and that was partly because everyone in the lower third of the class had become a Wall Street millionaire.”

He goes on, “Don’t get me wrong: the guys from the lower third of the class who went to Wall Street had a lot of nice qualities. Most of them were pleasant enough. They made a good impression. And now we realize that by the standards that came later, they weren’t really greedy. They just wanted a nice house in Greenwich and maybe a sailboat. A lot of them were from families that had always been on Wall Street, so they were accustomed to nice houses in Greenwich. They didn’t feel the need to leverage the entire business so they could make the sort of money that easily supports the second oceangoing yacht.”

I joined the Finance Department at the Wharton School in the fall of 1972. At the time they had one course related to commercial banking, but the course was structured to discuss banking structure and regulation.

I was interested in running banks so I made the suggestion that we offer a course in bank management that was similar to the courses in the financial management of corporations, only make it specifically related to the issues and concerns of the banking industry.

The response I received from some of the administration was that they were unsure that a course like that would attract many students, particularly at the MBA level. The reason being, that except for hiring several people that were interested in running bond portfolios, the large money center banks did not recruit from the Finance Department at Wharton.

Well, I knew that there were a lot of people from the University of Pennsylvania that worked at the large money center banks so I asked a stupid question: “Where did these banks recruit Penn grads?”

The response: “Oh, they recruit from the History Department, or the English Department or areas like that. What the banks really want are people that get along with others, enjoy social drinking, playing golf or playing tennis, who belong to social clubs and things like that. They don’t want someone that is mathematically trained or otherwise quantitatively orientated. They want someone to help establish or build relationships.”

Well, not that there weren’t smart people that graduated from History, or English, or areas other than math, statistics, physics, and finance. It’s just that, at the time, banks didn’t consider that these were the people they wanted working with their customers. I guess there is a bit of truth to Trillin’s op-ed piece.

Anyway, we did create the course in the financial management of commercial banks. In my last semester at Wharton the graduate class was held in a large auditorium and was completely filled. The textbook written for the course, The Financial Management of Commercial Banks can still be found on Amazon.com. (See http://www.amazon.com/Financial-management-commercial-banks-Mason/dp/0882623095/ref=sr_1_1?ie=UTF8&s=books&qid=1256315167&sr=1-1.)

The Collapse of Citi

Banking is a commodity business. Banking deals with information…I am holding $100.00of yours in something called a transaction account…I am holding your IOU for $1,000,000.00. Whereas, historically, these sums had to do with a physical quantity…something like gold…now all banking is basically conducted in 0’s and 1’s.

Banking is just information and the movement of information. Banking is a commodity business.

Yes, there are some other products and services connected with the banking business. There is safe keeping…you can get coin and currency back from you transaction account. We will clear payments for you though the banking system so that you can pay people from your account without the use of coin and currency and you can receive payments from other which will be put into your account. That is, we clear transactions through the banking system. We will do your accounting for you and send you a monthly statement. We will make loans to you and provide many different kinds of services for you connected with your loan. And there are many other products and services that banks provide their customers…individuals, businesses, and governments.

Banks used to get paid for these services primarily in interest payments or in deposit balances that were kept at the bank. In the 1980s, however, we got another idea. We can isolate these products and services, account for them, and then charge the customer fees for these particular products and services they use and then we, the banks, won’t have to build in payment for them in the interest rates charged on the loans or by means of the deposit balances that the customer had been required to keep at the bank.

Fees are good because they don’t depend upon loan or deposit balances, but depend upon other products or services rendered.

In the 1980s depository institutions found another way to generate fee income. In the 1970s the government had invented a new financial instrument called a mortgage-backed security that could help financial institutions make more money available to people who wanted to own homes and the depository institution could make these mortgage loans, securitize them so they could sell them and not hold them on their balance sheets, and collect fees for originating and, possibly servicing them. Furthermore, the banks would not have to worry about the interest rate risk that came from holding assets with long term maturities like mortgages and support them with deposits that were available on demand or had short-term maturities.

Banks liked fees and started to build businesses based on fee income. They looked farther and farther in an effort to find more sources of fee income. They built or acquired subsidiaries that generated fee income. And banking companies grew and became diversified…even conglomerate in nature.

But, the banks saw that more than just mortgages could be securitized and they saw that these securitized loans could be traded and in so doing more and more fees could be generated, but they also found that they could make trading profits from dealing in these securitized loans. And so banks began trading in securitized loans…otherwise called derivatives…and developing arbitrage strategies to take advantage of market discrepancies. But, to take advantage of market discrepancies they had to increase the amount of leverage they used so as to earn competitive returns.

Yet, the nature of banking did not change. Banking is a commodity business.

Not only is the business of borrowing money in the form of deposits and lending that money out to businesses and consumers in different kinds of loans a commodity business, the banks found that competition made all the products and services they offered into commodities as well. And, trading…well no one makes money over the longer haul on trading…because it, too, is composed of transactions in commodities.

Banks can earn a return on capital that is equal to what the capital can earn elsewhere given the normal risk a bank assumes. But, banks cannot mold themselves into institutions that can produce and sustain competitive advantages over other firms and industries. The business model they tried did not work. Yet, like other firms and other industries that come to believe in a business model that doesn’t work, their continued efforts to make the business model work only exacerbated the problem. Generally, this extra effort meant taking more and more risks and then even using extra-legal means to produce the results wanted.

I am not saying that banks committed fraud, but I have very serious concerns about the off-balance sheet practices along with other accounting efforts that the banks used in an attempt to generate the higher returns they felt they had to earn. However, the competitive pressure to perform does push people and organizations to walk the edge of ethical practices.

Citi…whatever…had a business model that did not work. And, this model was tested over about a decade…and it never worked. The investment community realized this and was only luke-warm about the company’s stock. Yet, management stuck with the model and tried all the tricks to make its business model work. They were true believers.

No one stood up, however, and mentioned that the emperor didn’t have on any clothes.

Banking is a commodity business. Citi…whatever…is said to be cutting back its organization by a third…and this is from the reduction in size that had already been achieved. They are supposedly getting back to fundamentals…into areas in which they have a core competency. Supposedly, its management has a better appreciation of the markets it will be working in. Let’s hope so.

And so the debt deflation goes on. The example of the banks…and of Citi-whatever…shows why it is so difficult to achieve a turnaround in the financial system and the economy during a time such as this. In the previous forty years or so, many companies, like Citi-whatever, took advantage of the almost continuous expansion of the economy and the government support of that expansion. Now the re-construction of these companies must take place.

The big question on the table right now concerns the stimulus plan being put together by President-elect Obama and his team. With companies…like Citi-whatever…drawing back and restructuring, how much effect can the stimulus plan have on the economy? The stimulus plan must not only attempt to reverse the economic down-term but must overcome the impact of the companies that are deleveraging their financial structure or are withdrawing from markets. The administration is shooting at a target that is moving away from it.

Commercial Banking and Bank Failures

Last Friday officials closed the tenth commercial bank this year. It was a small bank in Georgia with $1.1 billion in assets. The problem…rising loan defaults. The FDIC now has 117 banks on its list of institutions that are in danger of failing. The probability of a large number of these banks actually failing is quite large.

The failure of these banks does not get a lot of public attention. The reason for this is that most of these banks are relatively small and the losses they amass are not as eye-catching as the billions of dollars in charge offs of institutions like Merrill-Lynch and Citigroup. It is reported that the FDIC believes that the cost to the deposit insurance fund of this most recent failure to be in the neighborhood of $250 million to $350 million…a drop in the bucket.

But, the numbers add up as the number of defaults increases and the costs of a failure rises. Legitimate concern grows over the ability of the deposit insurance fund to handle future bank failures as well as the ability of the FDIC to administer a large number of failures. And, this doesn’t even consider some large bank failures that a few analysts assure us will take place. In terms of the losses in all financial institutions, the numbers, at present, are dominated by the overhang of the $200 billion that is the estimated cost of the Fannie Mae and Freddie Mac bailout.

The closing of commercial banks will only work itself out slowly over an extended period of time and, in general, the working out of these closures will be smooth and orderly. We are not in a liquidity crisis at this time, we are in a credit crisis. A liquidity crisis is a short term phenomenon where one side of the market, the ‘buy’ side, disappears. A credit crisis is a longer term situation in which borrowers default on their loans over time, a situation in which both sides of the lending transaction attempt to “work things out”.

A liquidity crisis occurs in a financial market where financial assets are traded on a regular basis. The essence of the market is the ability to buy or sell financial assets in a short period of time without having to make much price concession in order to complete a transaction. The liquidity crisis takes place when buyers are reluctant to acquire the asset and sellers have to substantially discount the assets they want to sell in order to have any hope of finding a buyer in the market.

The credit crisis that we are now going through in the commercial banking industry is one basically related to ‘non-market traded assets’. These are primarily assets that are on the books of the originator so that there is no market price which can be used to value the assets. These are loans made by the bank to a customer in which the bank keeps the loan that it has made. The customer then gets into a financial bind and either is unable to fully meet the terms of repayment or cannot repay at all.

In terms of banking practice, the commercial bank initially does nothing to adjust the value of the loan for the failure of the customer to meet the terms of the loan. The loan will first migrate through the bank’s delinquency report going from 30 days past due to 60 days past due to 90 days past due and so on. Loan collection efforts lag this movement through the delinquency list, going from computer generated delinquency notices to calls to direct collection efforts to ultimately selling the loan to a collection agency.

In my experience within the banking industry, the psychology of the management of a commercial bank goes from a belief that the customer is just have some timing problems, to “things will work themselves out”, to “we may have a problem here so let’s see how we can work with the customers and get things back on track”, to “we have a real problem here and we need to get tough”, to… Bankers have a real tendency to postpone action on the loans that they have put on their books because they have trouble believing that they have made a mistake. The loans are “personal”, something that shouldn’t happen in business. Right?

The consequence of this behavior is that substantial time usually elapses before commercial banks act on their loan portfolio problems. Examination and regulation can only partially speed up this process because the bank exams only take place periodically. Furthermore, it is the banks records and documentation that the examiners review and so time for observation and follow up must be allowed for. This is the reason for “watch” lists, not action.

The bottom line…the identification of bad loans and the process for correctly valuing these assets takes a long time. Consequently, a situation like the one we are in cannot be expected to work itself out quickly…the affects of the credit crisis will last of awhile.

One other issue in the banking arena I would like to discuss…start up banks. The bank that was taken over on Friday was located in the Atlanta suburbs. A Wall Street Journal article, (http://online.wsj.com/article/SB122004491643084379.html?mod=todays_us_money_and_investing) reports that sixty (60) banks were formed in the Atlanta area between 2003 and 2007! Sixty banks!!!

I live in the Philadelphia area. Just last night I passed a new bank that I had no idea where it had come from and who was running it. This just reminded me that new, small banks had been popping up all over the place in the last few years. The number of new start up banks in the United States must be astronomical over the last five years!

Why this is so astounding to me is that it indicates, to me, a real let down on the part of the regulators…on the part of the Federal Government. Putting many, many new institutions into markets that are well banked is extremely dangerous. Yes, big banks don’t serve local neighborhoods as well as do smaller banks with a local focus. Still, the smaller bank must establish a niche market and is usually desperate for quality loans. Emphasis is on growth so loan generation is a must. And, these loans are not made to sell because the new bank wants the balance sheet growth, so the loans are booked. “High quality” borrowers are generally taken up by existing banks so any effort to get these loans must include concessions on rate or term of some other element of the loan agreement that squeezes the new bank. More often the new bank must go after loans of lesser credit or into local speculative deals. The Wall Street Journal article says that the Atlanta area, during this expansion in banks, was “marked by overbuilding and loose lending practices during the real-estate boom.” The staff of the regulators had to keep up with all of these new banks at a time when the staffs were being contained for cost reasons and the bigger banks were going into more and more complex transactions.

This last comment raises another point. My experience is that many of these “professionals” that started up these new banks had a pretty high opinion of themselves. They think that they are pretty sophisticated. In one of the commercial banks I turned around, I was astounded by the Investment Policy the bank had concocted, the board of the bank had approved, and the regulators had never made mention of. This was a small startup bank that had been in existence maybe five years and had assets of about $100 million. Their investment policy allowed them to engage in some of the most sophisticated investment vehicles that existed at the time. In my review of the management that had been in place, there was no one…repeat, no one…in the institution that had any qualifications to transact in any of the investment vehicles they had the authority to invest in. And, this authority, written down and approved by the bank’s board of directors, had not seemed to bother the examiners and regulators at all! Why do I think that this picture could have been duplicated many times over in the last eight years?

One final point about the current situation: a credit crisis like the one that we are going through usually has an impact on the extension of credit going forward. Commercial banks that have just been burnt with charge offs and faced the possibility of extinction become risk averse and do not extend credit. Bank funds will not be readily available to support much economic expansion.