What's to Like About the United States Banking System?

I really don’t see much to like in the United States banking system. 

With interest rates so low across the board, commercial banks have very little interest rate spread to work with.

With Congress and the regulators so screwed up and yet so anxious to pass laws and regulate, the “regulatory risk” and the “complexity risk” facing the industry is enormous.

There is still plenty of evidence that commercial banks have a lot of unrecognized overvalued assets on their balance sheets. (http://seekingalpha.com/article/320370-bank-stress-tests-a-substitute-for-mark-to-market-accounting)

There seems to be growing interest in suing banks that are alleged of “making misleading public statements as the property market crumbled in 2007 to hide internal downgrades of loans from investors” (http://professional.wsj.com/article/SB10001424052970203735304577169360314402158.html?mod=ITP_moneyandinvesting_2&mg=reno-secaucus-wsj) or for other reasons that banks failed to appropriately disclose their financial condition.  There are also other settlements coming related to bank lending practices in the 2000s.

Bank earnings are a mixed bag, at best.  The larger banks are not performing well because trading profits and profits on many non-traditional banking operations are off.  (See JPMorgan and Citigroup)  The returns to trust banks (BNY Mellon, State Street Corp. and Northern Trust Corp.) are sagging because these institutions have taken a “defensive position” with respect to the financial markets and shifted a substantial amount of funds into cash and ultra-safe assets. (http://www.ft.com/intl/cms/s/0/140b9e70-41da-11e1-a586-00144feab49a.html#axzz1jqA4rKTp)

Only the banks that have stayed pretty much as traditional banks (like Wells Fargo, U. S. Bankcorp, and PNC Financial Services Group) have held up, profit-wise, in recent periods. This performance seems to be connected with some minor pickup in loan growth. 

Even in the case of loan growth, analysts are relatively pessimistic about the future.  “It appears that much of the commercial loan growth we have seen at the large cap banks is coming from large corporate syndicated lending.  Not all banks are players in this market.” This from Christopher Mutascio at Stifel, Nicolaus & Co.  Note that Mutascio is expecting “total loan growth and commercial loan growth” to slow in 2012.  No bounce here. (http://professional.wsj.com/article/SB10001424052970204555904577168510658669178.html?mod=ITP_moneyandinvesting_2&mg=reno-secaucus-wsj)

In my most recent blog I discussed the effort of BankUnited, a Florida-based bank, to sell itself because of the condition of the banking industry, especially in Florida.  BankUnited wanted to grow and yet could find no other banks to acquire…and they had looked at about 50 banks in the Florida region and elsewhere.  Because of the state of the banks available to acquire, BankUnited decided to sell.

Well, yesterday, BankUnited pulled itself “off the market”.  The bank had attempted to set up an auction for itself but only Toronto-Dominion Bank and BB&T Corp. submitted preliminary offers.  These offers did not come up to the price of that BankUnited received when it went public last year.  Thus, the bank withdrew its offer to sell. (http://professional.wsj.com/article/SB10001424052970203735304577169400198108514.html?mod=ITP_moneyandinvesting_1&mg=reno-secaucus-wsj)

Some of the banking statistics reflect the stagnant nature of the banking system as a whole.  For example, total commercial banking assets in the United States rose by about $700 billion last year. 

Note, however, that cash assets at commercial banks rose by about $515 billion!  That is, almost 75 percent of the growth in bank assets came from an increase in the cash holdings of the banks. 

Also, note that about 80 percent of this increase in cash assets at commercial banks in the United States occurred at foreign-related financial institutions. 

Furthermore, these foreign-related financial institutions increased their commitment to Net Deposits Due to Foreign-related offices by almost $650 billion.  Thus, these foreign related institutions took U. S. dollars and shipped them off-shore!  Thank you Federal Reserve System!

In all, the share of United States banking assets going to foreign-related financial institutions rose from about 11 percent to almost 15 percent from December 2010 to December 2012.  The largest twenty-five domestically chartered banks in the United States continue to account for almost 60 percent of the banking assets in the country.  The smallest domestically chartered banks (about 6,300 of them) continue to shrink as a proportion of banking assets. 

The American banking system is welcoming more foreign-related financial institutions to the ownership of its assets…note that one of the two bidders for BankUnited was Toronto-Dominion Bank…and is also seeing more and more of its assets being held by larger banks.

Right now, the commercial banking system seems to be going nowhere, just restructuring. 

This is just a very, very tough time for the banking system.  It is a time of transition.  The whole industry is changing. (http://seekingalpha.com/article/319449-the-banks-they-are-a-changing) But, then, the whole world seems to be going through a period of transition.  

The Banks, They Are A Changin'

The banking system is going through massive changes.  The morning papers are filled with stories about what is happening in the banking area, although they cover only a minor portion of what is going on in the industry.

The Wall Street Journal trumpets, “Bank of America Ponders Retreat.” (http://professional.wsj.com/article/SB10001424052970204409004577156881098606546.html?mod=ITP_pageone_0&mg=reno-secaucus-wsj) The current Bank of America represents, perhaps as well as any organization the excesses of the financial institutions over the past twenty years or so.  Currently selling at 33 percent of book value, the Bank of America can be potentially classified as one of the “Zombie” banks that now meander through the environment. (http://seekingalpha.com/article/319205-there-are-still-zombie-banks-around)

The Journal article does not give us much faith that management has a firm grasp on the situation…or, at least, is not revealing to us the reality that they face.  “Bank of America Corp. has told U. S. regulators that it is willing to retreat from some parts of the country if its financial problems deepen…”

The crucial hedge word is “if”.

Commercial banks have to recover from the binge that has taken place in the banking industry over the past fifty years.  This binge has seen commercial banks grow to enormous size and many have become “too big to fail.”  It has resulted in a massive shift in employment in the United States as the proportion of people working in the manufacturing trades has declined substantially relative to those working in the financial industry.  It has resulted in a huge shift in risk-taking in the industry, a move to more and more financial innovation, and a substantial increase in the amount of financial leverage used in the industry. 

Several of the articles in the morning paper discuss the reductions that are taking place employment.  For example, yesterday the Royal Bank of Scotland Group PLC announced that it will be laying off 3,500 people.  Cutbacks have also been announced by UBS AG and UniCredit SpA and well as Credit Suisse Group AG and many other major players.  The reductions in staff of the smaller institutions do not get as much publicity and play in the press. 

Some have argued that the industry is going through a cyclical shift that generally happens after a downturn in the economy but more and more industry analysts are claiming that they see a more permanent shift taking place.  And this is true of other parts of the financial industry than just the commercial banks.  “It isn’t just the lackluster business environment that is prompting banks to rein in their lofty investment-banking ambitions.  A realization is sinking in among securities-industry executives that because of the huge potential losses they are exposed to in bear markets, the business just isn’t as attractive as it once seemed.” (http://professional.wsj.com/article/SB10001424052970204409004577156833880721736.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj)

The fifty year period of credit inflation bought out over time many of the bad decisions and allowed the banks to go merrily on their way.  As “Chuck” Prince, former CEO of Citigroup expressed it…”As long as the music continued to play, people had to keep dancing.”

But, this continual pressure to grow and expand and take on more risk resulted in a massive change in the banking industry itself.  Going from around 14,000 commercial banks in the 1960s the commercial banking industry now contains less than 7,000 banks.  My forecast is for this number to drop below 4,000 in the next several years. 

And, the banking industry is bifurcating: almost two-thirds of the assets in the banking system are owned by the largest 25 banks in the country.  That leaves just one-third of the assets in the hands of about 6,300 banks.  More and more wealthier personal banking relationships are being handled by firms that cannot be considered to be community banks.  The products and services in these banks are many and the electronic interchange and access between financial assets and transactions are seamless and almost instantaneous.  

One could imagine a banking system in which the wealthier people worked with institutions like these and the less wealthy “banked” at non-profit credit unions, the non-profit institutions being the only ones that could provide the products and services needed without having to achieve a competitive return on shareholder’s equity.

The last factor producing major changes in the banking industry is the advances taking place in information technology.  Finance is nothing more than information.  That is, finance can ultimately be just a recording of 0s and 1s.  Thus, as information technology advances, so does the innovation in the financial industry. 

And, don’t think of how you use banking services right now…think about the electronic gadgets that your children or your grandchildren are using.  This is where you will see what financial institutions are going to need to provide for in the coming years.  What goes on in “electronic stuff” is real to these children and will become a part of the financial system as electronic finance becomes ubiquitous in the future. 

Furthermore, as advances in information technology has allowed “finance” to become more innovative, my guess is that for the future…we haven’t really seen what financial innovation can do.

This has tremendous implications for the regulatory efforts going on in the United States and the world.  I have argued for three years now that the efforts of the United States Congress and others throughout the world have been to create a regulatory system that will prevent a 2007-2008 financial collapse.  To me, the commercial banks in the United States are way beyond this system already.  Oh, the banks fight Congress and the regulators all along the way.  But, how much of this is real and how much of this is a smokescreen. 

Throughout my professional career…and I have run three banks…the banks have always been ahead of the legislators and the regulators in terms of what is going on in the banking system.  I am no less confident now that the banks are still far ahead of legislation and regulation and will continue to be so into the future. 

I can’t imagine what banking will be like in five years…but, it will be something substantially different than it is now.  It will be more electronic, it will be more innovative, and it will be harder to control.  The only way we can hope to keep up with what is going on is to increase the openness and transparency with which the banking system operates.   

European Bankers Balk at Big Write Downs

In my experience there are three ways for bankers with “bad” assets to move on.  First, the bank can “work out” the bad assets, but this takes time and in some cases a lot of luck.  The “lot of luck” component of this solution often refers to a recovery of the economy, local or national, that lifts up all asset values and brings the value of the “bad” assets more in line with the accounting values that exist on a banks’ balance sheet.

The second way is to get someone else to take over the “bad” assets.  Can the bankers find a “sucker” to acquire the “bad assets” at a price near book value and relieve the bank of the need to write down the value of the asset?  There are “suckers” out there, but the “suckers” then have the problem of having an overvalued asset on their balance sheet.  Of course, in some cases, the “sucker” turns out to be the government…or, should we say the “sucker” turns out to be the taxpayer. 

Third, the bank can write down the assets to a realistic value and get on with business. 

The first way is what bankers generally try to do.  Bankers are notorious for their optimism concerning the value of the assets on their balance sheets.  “We just need a little more time and everything will be fine.”  “The borrower just had some bad luck, but is getting things back in order.”  “The economy is improving and we just have to hold on until things get better.”  Of course, in the case of bonds on the balance sheet: “We plan to hold on to them until maturity.” 

In many cases, the old line applies: “People told to smile because things could be worse, so I smiled and sure enough things got worse.”

When the hole gets deeper the problem becomes more severe. 

I have successfully completed three bank turnarounds in my professional career and my general impression is that bankers tend to “look the other way” and postpone dealing with their problems, particularly when the problems pile up.  In many cases, the time runs out and the bank either has to be sold or taken over or has to be closed.

In terms of the second avenue, “suckers” are all around.  However, in the case of one bank “selling” a “bad asset” to another investor, the bank escapes the problem of dealing with an overvalued asset, but the “system” does not get rid of the overvalued asset.  It still has to be dealt with.  In the case of the government (Fannie Mae or Freddie Mac) buying the asset, or, as in the case of the FDIC closing a bank, or, in the case where the government “bails out” a company or an industry and sets up a company with the “bad assets, the government must absorb the difference between the accounting value of the asset and the market value of the asset.  The losses incurred in this way must be paid by the taxpayer over time. 

Admitting one made a mistake and writing down the value of assets is the only way for a bank to really get on with business.  This is a hard thing to do, but to recognize the problem early on and deal with the problem as soon as possible is the only way to allow the bank to get back to the business as usual.  If bankers take the first or second route mentioned above, they lose focus and their performance suffers. 

This is why I am such an advocate of banks marking their assets to market on a regular basis.  It forces them to address their problems as early as possible and after facing their problems head on, they can then turn their focus back to what they should be doing, making loans and building their customer base. 

Even in the case of the bankers buying long-term securities with short-term funds: bankers are doing this to increase the interest rate spread they earn.  They are intentionally taking on interest rate risk in order to improve their performance.  To me it is disingenuous for these bankers to act surprised and perplexed when interest rates rise and the market value of their long-term securities drop relative to their accounting value.

The problems bankers face related to overvalued assets can never really go away until the bankers fully embrace the situation and write down the value of their assets to realistic values.  The asset values must be written down to a level that, at least, eliminates the uncertainty about whether or not the bankers are fully recognizing the problem.

This is one of the freedoms of coming into a troubled situation to “turnaround” a bank.  The “turnaround” specialist can assume a “worst case” scenario and write down assets sufficiently to eliminate the uncertainty surrounding the value of the assets.  If the “turnaround” specialist does not do this, he or she is only creating further problems for themselves sometime down the road.  It is the only way to move on!

European banks still appear to be somewhere in the middle of these three paths to the future.  See, for example, the piece “Bankers Balk at EU push for Bigger Greek Losses” in Bloomberg this morning. (http://www.bloomberg.com/news/2011-10-16/bankers-balk-at-eu-push-for-bigger-greek-losses-higher-capital.html)

The problems faced by the European banks are huge.  The problems faced by European governments are huge.  The lack of fiscal discipline on the part of European governments for the past fifty years or so has caught up with both the governments and the banks that supported this deficiency.  Now, the governments and the banks find that they cannot continue to ignore the problem and hope for things to get better.  Furthermore, the governments and the banks cannot just push the problems off on the taxpayers.

Still they continue to hold out!

The only way the Europeans can resolve their current difficulties is to “bite the bullet” and accept the fact that several of the governments in Europe are insolvent and that the value of the sovereign debt issued by these governments must be written down to values that will eliminate the uncertainty pertaining to whether or not the governments are really accepting the severity of the problem. 

A difficulty inherent in this solution, however, is that the European Union may have to become more politically unified.  Letting the EU dissolve at this time is almost unthinkable and would end up, I believe, in an unconscionable banking catastrophe for the continent.  This may be the “unforeseen consequence” of the formation of the EU…that the crisis resulting from the way the union was initially set up may result in the nations of the EU forming a more unified political structure.  Imagine…

But, the financial problems will not go away as long as those running the governments of Europe continue to face up to the real issues and then deal with them.  The real issues relate to the fiscal irresponsibility of several of the European nations and the consequent insolvency that has resulted.  This insolvency is threatening the insolvency of the European banking system.

Unless this reality is accepted and acted upon, the crisis will just continue to play itself out. 

Why Banks Aren't Lending

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

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

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

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

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

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

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

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

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

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

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

Is there a problem here?  You betcha’!

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

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

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

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

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

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

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

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

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

Some Banks Are Stretching For Risk

According to Matt Wirz in his article “Banks Apply Lever to Cash Positions” in the Wall Street Journal, this morning (http://professional.wsj.com/article/SB10001424053111904103404576559100934308730.html?mod=ITP_moneyandinvesting_1&mg=reno-secaucus-wsj) some commercial banks, generally the larger ones, are stretching for higher yields by taking on more risk.

I have recently discussed this problem in several posts (http://seekingalpha.com/article/292286-will-bernanke-policy-destroy-credit-creation-bill-gross-is-worried-it-will, and http://seekingalpha.com/article/292446-will-bernanke-policy-destroy-credit-creation) and how it is related to the current policy of the Federal Reserve to keep interest rates at such low levels for the next two years.  Basically, commercial banks cannot earn the interest spreads they need with the term structure of interest rates being so flat.  And, any effort to achieve an even flatter yield curve through an “interest rate twist” policy will just exacerbate the situation.

With the term structure so flat, what is a bank to do? 

Rely on fees?

For an answer to this question see my recent post (http://seekingalpha.com/article/293657-bankers-expect-weak-profit-performance-in-the-future). Given the recent volatility in financial markets, larger banks are experiencing substantial shortfalls in trading and investment banking activity which is resulting in much lower fee income than in the past year or two.   New regulations are also resulting in lower fee income.

So with other sources of income shrinking, some banks are turning to higher risk loans in order to gain higher returns to “goose up” earnings.

According to Wirz, “Much of the lending is taking the form of so-called leveraged loans.  They are floating-rate loans made to companies with ‘junk’ or non-investment grade credit ratings, and typically used to finance buyout deals or refinance existing debt.”

In August, for example, leveraged loans totaled $36 billion, a small monthly amount for this year, yet the junk bond market and the IPO market only produced $2 billion combined. 

Wirz states, “there are signs that the risk in this line of lending is rising.  The large leveraged buyouts that banks arranged in the first seven months of the year carried 14 percent more leverage than those underwritten in the same period of 2010…That puts leverage on current deals on par with those financed in 2006, but below 2007 levels.”

Another type of risky loan, called pro-rata loans, is made to “stronger companies with junk ratings—typically rated BB—to boost interest earned…” This type of loan, through July of this year, is already up 16 percent from all of 2010.

Do we have here a case of the “law of unintended consequences”?  The Federal Reserve, in its fear that it will not do enough to prevent a double-dip recession, may be creating an environment that will result in outcomes that, over the longer-haul, may not be what it would like.

It is a good thing to get banks lending again and to get the economy expanding.  However, the loans that are being discussed in the above-mentioned article are not going to economy expanding business investment.  There are plenty of articles elsewhere that indicate there is not a robust amount of demand for loans on the part of businesses, especially those that deal with small- and medium-sized banks.  And, many small- and medium-sized banks are not that anxious to make more “new” loans, given the state of their balance sheets. 

Do we want banks to be making risk-stretching loans for the purpose of financing buy-out deals or refinancing existing debt?  

Historically, we see that this is not the way that the economy usually achieves more rapid economic growth.  Historically, additional risk taking is connected with periods of credit inflation.  Much of what the Federal Reserve has done in recent years, especially the execution of QE2, can be classified under the title of credit inflation. 

And, credit inflation is what we have experienced for the past fifty years!

The consequences of this credit inflation?

Higher rates of under-employment, unused manufacturing capacity, greater income inequality, a busted housing system, and sagging morale. 

Credit inflation does not result in improving productivity but instead results in speculation and bubbles.  As we have gone through the past fifty years, this is exactly what we have gotten…slower economic growth…and more financial innovation and risk exposure. 

Seeing commercial banks beginning to stretch for risk at this stage of the economic recovery is, to say the least, a little disconcerting. 

Bankers Expect Weak Profit Performance in the Future

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

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

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

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

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

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

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

The good old business of banking, what Leo Tilman calls “Balance Sheet Arbitrage”, is not doing so well these days and has been declining in importance for years. (See Leo Tilman book, “Financial Darwinism” and my review of it http://seekingalpha.com/article/221607-making-money-in-the-21st-century-financial-darwinism-create-value-or-self-destruct-in-a-world-of-risk-by-leo-tilman.) As financial market efficiency has improved through increases in competition and advances in the Internet and information technology, more and more bank customers have achieved greater access to more and more sources of to serve their needs.  As a consequence, there has been a secular decline in the net interest margin banks can earn.

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

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

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

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

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

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

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

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

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

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

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

The question is “Do Bankers Get It?”

The 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. 

The Future of Banking--Once Again

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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