Coming Crunch for Smaller Banks?

Two months ago I was hoping I was seeing some “Green Shoots in Smaller Bank Lending,” (http://seekingalpha.com/article/220685-green-shoots-in-smaller-bank-lending). Last month I found very little encouragement in the banking data released by the Federal Reserve: “Still No Life in Banking,” (http://seekingalpha.com/article/224851-still-no-life-in-banking).

The most recent data seem to indicate that things may be getting worse.

Remember, as of June 30, 2010, the FDIC listed 829 banks on its list of problem banks, and these banks are the smaller ones. Note that this is more than ten percent of the commercial banks in the banking system. Elizabeth Warren, in congressional testimony, has stated that there are at least 3,000 commercial banks facing major problems in the future, primarily in the area of commercial loans, (http://seekingalpha.com/article/215958-elizabeth-warren-on-the-troubled-smaller-banks.) I have made my own forecast that the number of domestically chartered banks in the United State will drop from around 8,000 to less than 4,000 in the next five years or so (http://seekingalpha.com/article/223340-say-goodbye-to-the-smaller-banks).

Total assets in the smaller banks in the United States (the smaller domestically chartered commercial banks consists of all banks below the top 25 in asset size and make up about one-third of the banking assets in the United States) are about the same this year as they were last year. Yet, cash assets in these banks increased by almost 38% from August 2009 to August 2010 and by more than 2% in the four week period ending September 29, 2010.

The concern, of course, is that the smaller banks are preparing for more trouble in the future. The larger banks are now in the process of reducing their cash assets: the cash asset at large, domestically chartered banks are down about 4% over the last four weeks; down about 5% over the past thirteen weeks; and down about 6% over the past year.

Thus, the decline in excess reserves that has occurred in the banking system over the last six- to eight-week period, has come in the big banks indicating that they are prepared to adjust to a new lower level of liquidity in the banking system.

However, the smaller banks are not ready to become less liquid, just the opposite. This, to me, indicates that the Federal Reserve is staying “extremely loose” not so much because the economy is weak, but because the solvency of the smaller banks in the banking system is in question.

There is no doubt that the smaller commercial banks in the United States are getting more conservative. Loans and leases at these smaller institutions continue to decline; they have dropped about one percent in the last four weeks.

The thing to keep an eye on, however, is the commercial real estate portfolio. In the smaller domestically chartered banks, the decline in these loans on the bank balance sheets seem to have accelerated in the past four weeks and in the past thirteen weeks from earlier time periods.

Commercial real estate loans have declined across the board, but the concern is that commercial real estate loans make up about 26% of the assets of the smaller domestically chartered banks and only are about 8% of the assets of the large banks. The declines in the smaller banks have a proportionately larger impact than does a similar decline in the big banks. Furthermore, this is where Elizabeth Warren pointed us to in her congressional testimony.

The two categories of loans that have recently increased at the smaller banks are “Revolving home equity loans” and “Credit card and other revolving plans.” The home equity loans at these smaller banks have risen by about 2% over the past 13-week period and are up slightly over the past 4-week period. At the big banks these loans are down by over one percent for the longer period and down slightly less than one percent for the shorter period.

Credit card and other revolving debt at the smaller institutions is up by over 4% in the past 13-week period and up by about 3% in the past 4-week period. At the larger banks, these numbers are down 3.5% for the longer period and down one percent for the shorter period.

Recent analysis of credit card debt indicates that, for the larger issuers, much of the decline in credit card debt has come because of these organizations charging off bad debt.

Could it be that the smaller banks are not charging off their delinquent home equity loans and credit card or revolving consumer debt because they don’t have the capital to absorb the losses? Could this be the reason that these loans are increasing at the smaller banks and not at the larger banks?

If one accepts this analysis, then the smaller banks have a lot to do on their balance sheets in the future to handle not only troubled commercial real estate loans but to handle revolving credit debt. Do the smaller commercial banks have the capital to go through this process?

There remain many concerns about the commercial banking system. Now that people expect that we will go through a period in which the profit performance of the larger banks is to be relatively flat, might this put even more pressure on the overall United States financial system?

My guess is that the big banks will do just fine. The problem is with the smaller banks, and the situation does not look encouraging for them. I still believe that this is the main reason why the Federal Reserve is keeping excess reserves in the banking system at such a high level. The Federal Reserve, in my mind, is scarred silly that there still may be massive bank failures in the future. The FDIC has been smoothly working through bank closures and helping many distressed institutions to find partners to absorb them. The question remains as to whether the massive amounts of liquidity in the banking system will allow this “work out” to continue its smooth and quiet pace in the face of growing problems with commercial real estate debt and consumer revolving debt?

Banks Remain on the Sidelines

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

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

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

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

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

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

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

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

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

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

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

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