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.   

Thrift Industry News--Down Again

The Office of Thrift Supervision (OTS) released statistics on the state of the thrift industry for the second quarter of 2010 on August 25. The industry is limping along, but the signs of a disappearing industry are all over the report.

The cloud over the whole industry is that the OTS will be merged into the Office of the Comptroller of the Currency (OCC) in the upcoming year. (See my post “So Long to the Savings and Loan Industry”, http://seekingalpha.com/article/214460-so-long-to-the-savings-and-loan-industry.) This, of course, is impacting decisions and affecting performance.

Two major figures stand out.

First, industry assets decreased by 15 percent from the second quarter of 2009 to the second quarter of 2010 to $931 billion from $1.1 trillion. From the second quarter of 2008 to the second quarter of 2009, industry assets fell by 27 percent from $1.51 trillion to $1.1 trillion.

Second, the number of supervised institutions declined from 792 thrifts at the end of the second quarter of 2009 to 753 at the end of the second quarter of 2010, just about a 5 percent decline. Yes, there have been thrift failures, but there has also been the constant drop in the number of thrift institutions in existence due to thrift conversions into commercial banks. This latter trend is expected to accelerate as the merger with the OCC proceeds.

One other interesting structural fact concerning the thrift industry I would like to mention. Of the 753 thrift institutions that exist, 402 of these thrifts are owned by 441 thrift holding company enterprises. These 402 thrifts have assets totaling $714 billion which represents 77 percent of all thrift assets. But, one should also note that these thrift holding companies control approximately $4.1 trillion in United States domiciled consolidated assets.

Note that at the end of the second quarter of 2009, there were 459 thrift holding companies supervised by the OTS and these institutions control $5.5 trillion in U. S. domiciled consolidated assets. The decline from this figure to the second quarter 2010 figure is over 25 percent.

Just in comparison, according to the National Credit Union Association, there are close to 7,500 credit unions in the United States, down about 250 from the same time in 2009. However, assets at these credit unions totaled almost $900 billion at the end of the first quarter of 2010, up just about 5 percent from the end of the same quarter in 2009. Total shares and deposits at credit unions rose by 6.7 percent, year-over-year, to a little over $773 billion. The credit union industry continues to grow and in many areas of the country, Philadelphia for one, major expanded credit unions are becoming a force in the local banking markets.

Overall, in the aggregate data released by the Federal Reserve, deposits at all thrift institutions, including credit unions, rose by 0.5 percent from July 2009 to July 2010. The conclusion one can draw for these numbers is that funds are leaving the OTS regulated thrift institutions to go to commercial banks and credit unions.

It is going to be very interesting to watch the credit union sector over the next several years. The interesting question here is whether or not the larger, expanding credit unions can pick up the consumer funds that are leaving savings and loans, savings banks, and commercial banks. Could the banking industry bifurcate into primarily “business” banks and “consumer” banks?

Given all the other factors that are impacting depository institutions one can safely say that the whole landscape of banking and finance is going to change dramatically over the next five to ten years.

Bank Holding Companies and Other Financial Institutions

Bank Holding Companies

The Flow of Funds accounts from the Federal Reserve System just came out today. This gives us a chance to look at parts of the financial system that we do not get to look at on a more frequent basis.

In terms of the banking sector, one area of interest at this time is the activity going on in bank holding companies. In terms of assets, bank holding companies, at the end of the third quarter, 2009, are holding $2.8 trillion in assets, up from $1.9 trillion one year ago and up from $1.8 trillion at the end of 2007. So assets in bank holding companies rose by almost 50% in the past year.

The large increase in assets came in the area of investments in nonbank subsidiaries. The rise from the end of the third quarter of 2008 was $537 billion, or 135%. The increase since the end of 2007 was $592 billion, or an increase of 172%

These holding companies also increased their investment in bank subsidiaries as well, but only by $164 billion or by 14% since the end of the third quarter 2008. The increase since the end of 2007 was $188 billion.

Financing this increase in assets was an increase in bonds issued by these holding companies and in residual equity. The net increase in corporate bonds issued was $508 billion for the year ending in the third quarter of 2009. The net increase since the end of 2007 was $553 billion.
There was roughly an $400 billion increase in the residual equity of these organizations during this time period. The increase in residual equity since the end of 2007 was approximately $500 billion.

These increases in bank holding company assets took place at the same time that total assets in U. S. chartered commercial banking sector rose only by about $139 billion from the third quarter of 2008 to the third quarter of 2009. It should be noted that during this same time period total bank loans in the banking industry declined by almost $383 billion, with reductions taking place in every category of loan.

Note that since the end of the third quarter 2008, vault cash and reserves at the Federal Reserve rose by $384 billion. The increase since the end of 2007 was $540 billion.

It is obvious that banks and bank holding companies are not doing the ordinary business of banking.

The commercial banks, themselves, are becoming “pools of liquidity”, but they are not lending.

It seems that bank holding companies, however, are further diversifying into nonbank subsidiaries because of the tremendous opportunities for profit that are now available to them in these areas. Also, it seems as if this is all happening for the largest banks and the largest bank holding companies.

So, here is the picture: commercial banks are essentially static right now; nothing is happening in the industry as a whole.

Bank holding companies are moving ahead full steam: and what they are doing is very, very profitable!

Saving Institutions

The thrift industry continues to shrink!

In the last four quarters, the total financial assets in savings and loan associations, mutual savings banks, and federal savings banks fell by $145 billion, or by about 10%, to just $1.4 trillion. Since the end of 2007, financial assets have fallen by $442 billion, or by about 25%.

One really has to wonder about the existence of this part of the finance industry and the need for such an expensive regulatory structure to support it.

Its main reason for existence, the issuing of mortgages, continues to erode as mortgages on the books of these savings institutions fell by $155 over the past year, an 18% decline. Since the end of 2007, mortgages at these institutions fell by $367 billion, a decline of one-third. Statistics indicate that, on average, institutions in this industry are just about breaking even, profit-wise.

Although it is not getting a lot of headlines in the press, the savings industry is not doing too well. Maybe it is now too insignificant to warrant much attention!

Credit-Unions

Credit unions continue to grow. They ended the third quarter at $873.4 billion in total financial assets, increasing by $73 billion over the last four quarters.

One wonders when the total assets at credit unions are going to exceed that at savings institutions.

Although the totals are not large, credit unions continue to increase their loan portfolios across the board.

The total amount of credit extended by credit unions was $592 billion at the end of the third quarter 2009, roughly two-thirds of the $875 billion in loans on the books of savings institutions. Credit unions have only about 63% of the assets that savings institutions do.

Mortgages on the books at credit unions are about 44% of the amount of mortgages that sit on the books of savings institutions, up from 35% at the end of the third quarter in 2008. But, consumer loans are 308% of the total of consumer loans at savings institutions. This is just a little higher than it was one year ago.

Credit unions seem to be doing very well and continue to be on the rise!

The Problems of the Savings Industry

In an earlier post I reported that the weakness being experienced in the year-over-year rate of growth of the M2 measure of the money stock could be attributed to shifts in deposits from thrift institutions into commercial banks. (September 25: http://seekingalpha.com/article/163456-thrift-struggles-dragging-down-m2-growth.)

On Tuesday, September 29, I wrote about commercial banks and how bank holding companies had raised a substantial amount of funds in the capital markets from the second quarter of 2008 to the second quarter of 2009 but most of the funds raised by these institutions went into non-bank subsidiaries. Chartered U. S. banks saw some increase in assets over this time period but these funds went into cash assets, government or agency securities, and mortgages, mostly of the commercial type.

We also have data from the flow-of-funds accounts that give us some insight into what is happening at savings institutions and credit unions. The real success story seems to be that connected with credit unions. The credit union industry ended the second quarter of 2008 with almost $900 billion in financial assets. All other savings institutions had assets of about $1,400 billion and the Office of Thrift Supervision (OTS) reported that thrift institutions had assets that amounted to only $1,100 at the end of the second quarter.

Who would have ever thought that the credit union industry would ever be about the same size as the thrift industry?

Credit Unions grew by $73 billion, year-over-year, and the credit that they extended seemed to expand during this time period at a fairly steady pace.

The bad news: savings institutions, which include savings and loan associations, mutual savings banks, and federal savings banks, performed abysmally. For one, industry assets, according to the OTS fell by 27% over the last year, reflecting the failure and sale (to commercial banks) of several large thrift institutions. Total loans at these institutions fell by 35%.

The total decline in financial assets for the industry was $420 billion: the mortgage portfolio of the industry declined by almost a third or $360 billion. Consumer credit also declined by about $14 billion.

According to the OTS, the industry as a whole earned a profit of $4 million—yes, that’s million—in the second quarter. This is the first quarterly profit since the third quarter of 2007.

The industry added almost $5.0 billion—yes, that’s billion—to loan loss provisions in the second quarter. This loan loss provision was exceeded in history by only five other quarters. However, these five other quarters were the five quarters just preceding the second quarter of 2009.

The OTS reports, however, that “96.2% of all thrifts exceed ‘well-capitalized’ regulatory standards.” These institutions, we are told comprise 95.9% of industry assets but most of them are relatively small. So, institutions with approximately $45 billion in assets are in not “well-capitalized” thrifts, by industry standards. The number of problem thrifts reached 40 at the end of the second quarter.

Yet the industry has about $40 in what are called troubled assets, about 3.5% of Total Assets. Troubled assets are noncurrent loans and reposed assets.

It seems as if the thrift industry is dying and needs to be consolidated and merged into the commercial banking industry. (And this from a person, myself, who successfully turned around two thrift institutions.) I don’t believe that there should be a merger of thrift institutions with the credit union segment of the industry. Credit unions seem to be doing something right. (I have worked, in recent years, with groups to form three credit unions and I believe that credit unions can fill a very important gap in consumer finance, credit and banking services.)

The thrift industry played a very important role in the history of the United States (and elsewhere in the world). In the current era of securitization and financial innovation, I believe that savings institutions have exceeded their useful lifetime. The savings and loan crisis saw the collapse of the industry and the 2000s just verified that the industry really needs to continue to shrink and become incorporated into other segments of the market.