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.   

Business Lending is Increasing, Especially at the Largest US Banks

Business lending continues to accelerate in US commercial banking system according to the latest data released by the Federal Reserve System.  Although overall lending has not increased by much in the commercial banks, only about $27 billion year-over-year at all domestic and foreign-related institutions, business loans (commercial and industrial loans) rose by more than $95 billion. 

True, many of these loans have gone to support acquisitions and other uses that are not directly related to expanding economic expansion.  Still, it is good to see more life in this particular area of bank lending.

Most of the increase in business lending came from the largest twenty-five banks in the country and foreign-related financial institutions.  Business loans did increase modestly at the small- and medium-sized banks, but not by much.

Commercial banks continued to allow their real estate and consumer loans to run off, the largest declines coming in the commercial real estate area.  All real estate loans at commercial banks decreased by almost $160 billion, year-over-year, with $86 billion of the decline coming at the largest twenty-five commercial banks and almost $70 billion coming in the rest of the domestically chartered banks.  The largest proportion of these declines came in the commercial real estate area. 

Consumer loans declined by about $41 billion in the whole banking system, year-over-year, with $38 billion of the decline coming in the largest 25 banks.

On another note, one can still see how the Federal Reserve is helping to finance banks in the eurozone.  Cash assets in the whole commercial banking system rose by almost $620 billion, year-over-year, with the rise at the foreign-related financial institutions absorbing almost $490 billion of the total.  At the same time the net deposits to foreign offices at these foreign-related financial institutions rose by more than $590 billion.  The average increase in these net deposits to foreign offices over the past month was another $50 billion. 

The Federal Reserve has done what it can to supply liquidity to European-related financial institutions to help them through the recent financial crisis.

I still have substantial concern about the smaller commercial banks in the United States.  The statistics still do not look good to me.  The total assets at the “smaller” banks rose by about $58 billion over the last year, but over $39 billion of that increase came in the cash assets of these institutions.  Although business loans at these institutions rose modestly, as mentioned above, total loans at these “smaller” banks dropped by almost $60 billion.  These “smaller” banks are just not growing.

A very large number of these smaller banks are just “sitting on their hands” hoping to survive.  These banks are doing everything they can to work out their loan portfolios and to become more liquid.  The reserves for bad assets have declined, but these declines are coming at the healthier banks.  And, given the low interest rates that can be earned on securities, the profits of many of these smaller banks are not sufficient to help them recover from the bad assets that are still on their balance sheets.  It is just amazing the numbers related to bad commercial real estate loans that are on these balance sheets. 

One could say that the good news is still related to the fact that there are not major disruptions occurring in the commercial banking sector.  This “peace and quiet” allows the FDIC to close as many banks as need to be closed without a big fuss.  This year 85 banks have been closed, just under 2 per week.  This figure, however, does not include the decline in the number of banks still open due to acquisitions.  I am still expecting some 2,000 or so commercial banks to drop out of the banking system over the next five years or so. 

It is hard to imagine that bank lending will grow much in the future given all the vacant residential real estate and commercial real estate that is around and all the foreclosures that are still to come.  An examination of the commercial banking sector does not give us much hope about the possibility of a more rapid expansion of the economy. 

The Smaller Banks Continue to Lose Ground

First, we need to define what the Federal Reserve calls “Small” banks.  The Federal Reserve defines small banks as domestically chartered banks that are not counted among the largest 25 domestically chartered banks in the United States.  Hence, “Large” domestically chartered banks are the largest 25 domestically chartered banks in the United States. 

As of September 7, 2011, the largest 25 domestically chartered commercial banks in the United States account for 56 percent of all the banking assets in the United States.  The smaller banks represent about 28 percent.  Foreign related financial institutions control about 16 percent.    

From August 2010 to August 2011, the total assets held by the small banks in the United States grew by one-half the rate at which the total assets in the largest 25 banks.  The “large” banks grew at a 1.4 percent annual rate while the “small” banks grew by 0.7 percent.

Over the last calendar quarter from the banking week ending June 1 through the banking week ending September 7, the smaller banks actually shrank by almost $20 billion while the larger banks grew by about $165 billion. 

Over this last quarter, “Loans and Leases” at the smaller institutions dropped by almost $70 billion.  At the largest 25 banks, “Loans and Leases” rose by over $130 billion.  At the smaller banks, loans fell in ALL categories. 

From the banking week ending August 3 through the banking week ending September 7, “Loans and Leases” at the smaller banks rose by only $1.5 billion while they rose by more than $30 billion at the 25 largest banks. 

One could say that lending activity is increasing on Wall Street but not on Mail Street.   One could ask questions, however, about the type of loans that the larger banks are initiating.  See my posts from last week: http://seekingalpha.com/article/293657-bankers-expect-weak-profit-performance-in-the-future and http://seekingalpha.com/article/293893-some-banks-are-stretching-for-risk.   

But, business loans are not suffering the most at the smaller banks.  Over the past year, residential real estate loans (home mortgages) at these smaller banks have declined by more than 6 percent, year-over-year.  Over the past quarter these loans have fallen by $12 billion. 

And the smaller banks still are suffering through the commercial real estate decline as these loans declined by almost 7 percent, year-over-year through August.  Commercial real estate loans at these banks declined by more than $40 billion over the last quarter alone. 

The FDIC reports that there were 6,413 commercial banks in the banking system as of June 30, 2011.  Of this number, 865 banks were included on the FDIC’s list of problem banks for this date, more than 13 percent of the banks in insured at that time.  Troubled banks total even more than this, some estimate that more than twice this number are very fragile institutions. 

From these data one can argue that bank lending activity may be picking up, but it is not picking up among many of the smaller banking institutions that still face serious balance sheet troubles.  These organizations are not going to participate in any economic recovery and, in fact, are going to have to be closed or absorbed into the banking system that will remain.  As mentioned above, even though loans may be picking up in the largest 25 banks in the country, the loans may not be going into the physical investment that would cause the economy to grow faster than it is. 

FOREIGN RELATED INSTITUTIONS, QE2, AND THE EUROPEAN BANKING CRISIS

Dollar deposits continue to flow out of the United States into foreign banking offices through domestically located foreign related institutions.  From August 2010 through August 2011, cash assets at these domestically located foreign related institutions rose by about $470 billion!  This increase in cash assets tracks closely the Federal Reserve’s implementation of QE2 and represents about 75 percent of the roughly $630 billion rise in cash assets of the whole United States banking system. 

The interesting thing for our purposes is that the item on the other side of the balance sheet that most closely tracks this increase in the cash assets of foreign related banking institutions is “Net Due to Foreign Offices.”  That is, this money is going off shore. 

From August 2010 through August 2011, this account, “Net Due to Foreign Offices”, rose by almost $540 billion.  In the last quarter it rose by over $160 billion.  In the last month it rose by $112 billion. 

Can the rise in this this account be associated with the sovereign debt crisis in Europe and the recent problems faced by many of the large European banks?

I believe one can make a pretty strong case for this conclusion.  The Fed’s QE2 preceded the agreements that the central banks made last week to provide more US dollars to European banks. 

Of course, this provision of US dollars to the world is not spurring on economic growth although it may be helpful to preventing another Lehman Brothers meltdown.  

Federal Reserve Money Continues to go Off-Shore

Yesterday in my post I reviewed the consequences of QE2 on the Federal Reserve balance sheet. (http://seekingalpha.com/article/276674-qe2-watch-no-qe3-in-sight)

The bottom line: “The ‘net’ increase in securities held outright by the Federal Reserve has been $589 billion, pretty close to the $600 billion ‘net’ increase promised.

Reserve balances at Federal Reserve banks, a proxy for excess reserves in the banking system, have increased by $584 billion to $1,594 billion over this time period. Actual excess reserves in the banking system averaged $1,610 billion for the two-week period ending June 15, 2011.”

Cash assets (excess reserves) at commercial banks in the United States rose by about $800 billion from December 29, 2010 to June 15, 2011 and closed slightly below $1,870 billion on the latter date. 

Basically the Federal Reserve pumped all these reserves into the banking system and there they seemingly sit.  Yet, the amazing thing is that of the almost $800 billion increase in cash assets in American banks, almost 85 percent of the increase, or about $670 billion, ended up on the balance sheets of Foreign-related Institutions in the United States. 

And, what increased on the other side of the balance sheet?

Net deposits due to related foreign offices.  These balances rose by almost $500 billion since the end of last year. 

In essence, it appears as if much of the monetary stimulus generated by the Federal Reserve System went into the Eurodollar market.  This is all part of the “Carry Trade” as foreign branches of an American bank could borrow dollars from the “home” bank creating a Eurodollar deposit.  This Eurodollar deposit could be lent to foreign banks or investors and this would not change the immediate dollar holdings of the American bank.  This lending and borrowing in Eurodollar deposits could then multiply throughout the world.  And, the American bank might be the ‘foreign-related” institution mentioned above and included in the statistical reports.

Note that the original dollar deposit created by the Fed is still recorded as a deposit at one Federal Reserve bank no matter how much shifting around the borrowing and lending in the Eurodollar market occurs.    

Thus, it appears as if the Federal Reserve pumped one-half a trillion dollars off-shore since the end of 2010!

And, this is going to stimulate spending and getting the economy to grow faster?

Cash assets at the smaller banks remained relatively flat over the last six months…and over the last three months.  Thus, the reserves the Fed was pumping into the banking system were not going into the smaller banks. 

And, although the largest twenty-five banks in the country increased their cash assets by about $130 billion over the last six months, these banks have been reducing their cash balances (by a little more than $30 billion) over the last three months. 

What have the domestically chartered commercial banks been doing over the last six months?

Basically, the twenty-five largest domestically chartered commercial banks have been modestly increasing their loans to businesses, both in the three-month period and the six-month period.  Commercial and Industrial loans as well as commercial real estate loans have been increasing at the largest banks over the past three-month period. 

However, business loans continue to “tank” at the smaller banking institutions.  For example, Commercial and Industrial loans at the smaller institutions dropped by almost $5.0 billion from March 30 to June 15.  Commercial Real Estate loans took an even bigger hit of almost $35 billion. 

Also, at the smaller banks, residential mortgages continue to decline…by a little over $9.0 billion since March 30 and by almost $35 billion over the last six months. 

The real lending by commercial banks is not taking place in the United States.  The lending is taking place off-shore, underwritten by the Federal Reserve System and this is doing little or nothing to help the American economy grow. 

It does seem to help produce inflation elsewhere which gets translated back into the United States in the price of imports.

The Fed has not yet gotten bank lending going, it has not yet caused an increase in the money stock measures, and it has not yet stimulated the economy to any degree. 

The Fed may have helped the FDIC close banks in an orderly fashion and it may have helped raise the prices of commodities world-wide. 

For all the efforts exerted in QE2, the results are not very encouraging.

NOTE: As mentioned in my post yesterday, I will not be posting anything for about a week or so.

The Small Banks Are Going Nowhere

Over the past six months or so the total assets of the smaller banks in the United States (smaller than the largest 25 banks) have remained relatively constant. Total assets averaged about $3.6 trillion in September 2010 and they averaged just below this number in March 2011.

And, given the Federal Reserve’s QE2 policy which has caused the cash assets of commercial banks in the United States to increase by almost $350 billion over this time period, the cash assets of these smaller banks remained roughly constant.

Over the past 13-week period, total assets at these smaller banks increased a modest $3 billion, but over the last 4-week span of time, total assets dropped by almost $10 billion.

Cash assets (over the past 13 weeks) rose by slightly more than $3 billion at a time when the total cash assets of the whole banking system were increasing by more than $480 billion.

The smaller commercial banking sector seems to be going nowhere.

What about credit extension amongst these banks?

Loans and leases at the smaller banks dropped by more than $8 billion over the last four weeks. The drop over the last thirteen weeks was slightly more than that.

And the largest 25 banks?

Total assets at the largest banks have increased by $60 billion over the past four weeks and by almost $90 billion over the last thirteen weeks. Most of the growth these largest institutions have come in cash assets. However, the increase in cash assets at the largest 25 banks in the United States has been small relative to the increase in the cash assets of foreign-related financial institutions in the United States. (See http://seekingalpha.com/article/262788-fed-s-monetary-policy-cannot-be-conducted-in-isolation.)

And, what about bank loans at these larger banks?

Since the end of 2010, loans and leases at commercial banks in the United States have declined by about $105 billion; and over the last four weeks of the first quarter, loans and leases at large commercial banks have declined by about $11 billion.

Business loans have rallied some over the last thirteen weeks, up a little more than $12 billion, but $10 billion of this increase has come in the last 4-week period.

Real estate loans have plummeted at commercial banks both over the last four weeks and the last thirteen weeks. The declines have come in both residential and commercial real estate loans.

And, what asset class, other than cash assets, has increased the most at the larger financial institutions? The securities portfolio.

So, the update on the banking industry as of the end of the first quarter of 2011?

The smaller banks, as a whole, continue to be in a holding pattern. And, QE2 seems to be doing little or nothing for these institutions. The cash reserves the Fed is pumping into the banking system is going to either the foreign-related financial institutions in the United States or the largest 25 commercial banks in the United States.

The smaller banks are not increasing their loan portfolios.

For the larger banks, QE2 is having some impact as cash reserves at the largest banks are increasing and the securities portfolios of these institutions are also increasing.

However, loans, as a whole, are not increasing…although there seems to have been a little pickup in the area of business loans.

Overall, one sees very little evidence that the Fed’s QE2 is having any impact on bank lending which, of course, does not provide much evidence that economic growth is going to begin accelerating in the near future.

Not very encouraging.

Is Bank Lending to Business Starting to Pick Up a Little?

Last month I wrote a post about “Why is most of the Fed’s QE2 Cash Going to Foreign Related Banking Institutions.” ( http://seekingalpha.com/article/254004-why-is-most-of-the-fed-s-qe2-cash-going-to-foreign-related-banking-institutions)

This month the Fed’s “cash” injection has ended up at the largest 25 banking institutions in the United States. Cash assets at the largest domestically chartered banks rose by almost $160 billion over the past four weeks.

The cash assets at foreign-related banking institutions dropped modestly (about $4 billion) over the last four weeks but is still up approximately $125 billion since the end of last year.

According to the Fed’s data on the commercial banking industry, cash assets in commercial banks have risen by about $260 billion over the past nine banking weeks, with around $135 billion going to the largest 25 domestically chartered banks, $125 billion going to foreign related financial institutions and roughly zero going to the other 7,600 domestically chartered small banks.

Other than this fact, the interesting change within the United States banking system itself is that although credit extension at domestically chartered commercial banks declined rather substantially since the end of last year, the loans and leases at the smaller commercial banks actually went up.

Overall, loans and leases on the books of commercial banks declined by about $27 billion over the last four weeks and by $61 billion since the end of 2010.

Interestingly, the smaller banks recorded a $28 billion increase in loans over the last four weeks, with commercial and industrial (C&I) loans rising by $5.5 billion and commercial real estate loans increasing by about $18 billion.

It should be noted that residential mortgages fell by about $11 billion over the same time frame.
Is this a sign that commercial lending is picking up for the smaller banks. This is the first time in the last few years that commercial lending has actually shown any sign of increasing at these smaller institutions, especially in the area of commercial real estate.

C & I loans did pick up at the larger banks over the last four weeks and this dominated the activity in this area during the early part of this year.

However, commercial real estate lending declined at the largest banks by $25 billion, so that this category of loans did decline in total. Also, since the end of last year, commercial real estate loans at these large banks declined by $32 billion so that overall, the commercial real estate sector continued to decline throughout the early part of 2011.

So, the question is, “Is bank lending to businesses starting to pick up a little?”
Really, we only have a little information that it might be picking up. But, it certainly is something to keep our eyes on.

The big mystery still seems to be the placement of the QE2 money being generated by the Federal Reserve system. Reserve balances at Federal Reserve banks have increased by about $280 billion from the end of 2010 to March 2, 2011. This increase in Reserve Balances seems to be roughly divided between the largest 25 domestically chartered commercial banks and foreign-related financial institutions. But, loan at these institutions over this time period have actually gone down. What’s going on?

As for the smaller banks, they do not seem to have participated in this round of quantitative easing. Yet, it has been my belief that one rationale for QE2 has been to provide market liquidity for the smaller banks so that it will ease the strain on those banks that are especially having solvency problems. Given recent data released by the FDIC it seems as if there are still a large number of the smaller banks in the country that are still having major problems staying alive.

Thus, at least part of the purpose of QE2 is to help keep these banks open so that they can be closed by the FDIC in an orderly fashion. Through the first nine weeks of the year the FDIC has closed an average of just under 3 banks per week. This is down slightly from about 3.5 banks a week in 2010.

We continue to wait. Believe it or not, the economic recovery is just about a quarter short of being two years old. There are still areas of the economy that remain of concern like the banking industry, the residential housing market, the commercial real estate market, and state and local finances. And, there still are shocks around the world that threaten to bring everything else down: the unrest in the Middle East and arising oil prices; the earthquake in Japan; and the sovereign debt problem in Europe.

So the bad news is that the economic recovery is just about a quarter short of being two years old and underemployment is so large and manufacturing capacity is so low for this time in the business cycle.

The good news is that the economic recovery is just about a quarter short of being two years old
and the recovery seems to be robust enough to continue to meander along in an upward direction.

It would be nice to have more bank lending to spur the recovery along, but it will be even better if the financial system can continue to function without a disruption to the steady pace of the FDIC closing the banks it needs to close.

The Two Banking Systems in the United States

More and more it appears as if the banking system of the United States is bifurcating into two parts, the largest 25 banks and the rest. These designations, large and small, are used by the Federal Reserve System for the data they release for the whole commercial banking system.

Over the past year, the total assets of the domestically chartered commercial banking system in the United States hardly grew at all. Yet, throughout the year, the smaller banks made their balance sheets much more conservative than did the largest banks.

For one, the smaller commercial banks increased their holdings of cash assets by 10% from December 2009 to December 2010; the largest banks decreased their cash holdings by more than 21%.

Both the large banks and the smaller banks increased their securities portfolios over the year, but the smaller ones increased their securities portfolios by almost 9% while the largest banks increased theirs by only about 3%.

Over the whole year, Commercial and Industrial Loans declined across the board with the larger banks portfolio of C&I loans dropping by almost 5% while in the smaller banks, C&I loans fell by only about 3%. Real Estate loans also fell during the year dropping about 4% and 5% at the largest and the smaller institutions, respectively. Consumer loans were re-defined over the year for this Federal Reserve release so that the data year-over-year growth rates are not meaningful.

The largest declines since December 2009 came in commercial real estate loans. At the largest banks, commercial real estate loans dropped by almost 11%; at the smaller banks they fell by 8%. The troubles in the commercial real estate area show up very clearly in the banking statistics.

The conservative movement in the balance sheets of the smaller banks was continued over the last 13 weeks ending with the banking week finishing on January 5, 2011. Total banks assets fell during this time period, but not by very much. Over this time period, however, the smaller banks increased their holdings of securities by over 7% while their loan portfolios fell by more than 3%.

During this time period, loans making up the loan portfolios of the smaller banks fell across the board: C&I loans dropped by 4%; real estate loans fell by 3%; and consumer loans declined by about 4%.

The loans at the smaller banks also continued to drop through the Christmas season with C&I loans falling by over 2% in the five-week period ending January 5, 2011; real estate loans fell by just 2% during this time period; and consumer loans dropped by almost 5%.

Interestingly enough, there was a front page article in the Saturday Wall Street Journal with the title “Banks Loosen Purse Strings” which reported data from Equifax Inc. and Moody’s Analytics. (http://professional.wsj.com/article/SB10001424052748704637704576082300851916930.html?mod=WSJPRO_hps_LEFTWhatsNews) In this article the claim is made that “In the third quarter (of 2010), lenders made more than 36 million consumer loans, up 3.7% from a year earlier...That is the first year-over-year gain since the crisis began. Consumer-loan originations are expected to climb 5.9% this year, much higher than the slim 1.1% increase in 2010.” The article goes on to say that “The totals include bank-issued and retail credit cards, auto loans, consumer-finance loans, home-equity lending and student loans”. Whoops, these are not all banks are they!

But, the commercial banks do not seem to be opening their purse strings when it comes to consumer lending. Besides the drop of 5% in consumer loans at the smaller commercial banks, the Federal Reserve data also showed that consumer loans fell by 5% at the largest 25 commercial banks over the past 5 weeks.

Again, the largest declining loan class over the last 5 weeks was still the commercial real estate loan area. The decline at the largest banks in the last 5 weeks was a little under 1%, while the decline at the smaller banks in this area was over 2%.

Everywhere, the aggregate banking statistics can be interpreted as showing that the smaller commercial banks continue to “tighten up” their balance sheets. The loan portfolios of these banks experienced further declines while the banks keep building up their cash positions and the size of their securities portfolios. The largest contractions have come in commercial real estate, the area that seems to have the biggest cloud over it for the next year or two.

Generally, the largest 25 domestically chartered banks in the United States seem to be doing well.

Of course, we all heard about the 47% profit jump at J.P.Morgan Chase which was announced on Friday. This week we will get more information on how the other “large” commercial banks are doing. It is expected that the reports coming out this week will show that the bigger banks are pulling ahead.

Of interest is the areas of lending that seem to be picking up at these larger banks. For one, commercial and industrial loans are, indeed, starting to increase. Over the past 13-week period, the largest 25 banks saw their portfolios of C&I loans increase by more than 3%; these loans also showed a gain over the past 5-week period.

The one other lending area that seems to be picking up at these larger banks is the area of residential loans, mortgages. (Note: this does not include equity-line loans.) Over the last 13-week period, residential real estate loans have picked up by slightly more than 3%; these loans also registered a modest increase over the last 5-week period.

So, I still firmly believe what I wrote in my January 3, 2011 post, “Four ‘Uncomfortable Situations’ to Watch in Early 2011,” (http://seekingalpha.com/article/244531-four-uncomfortable-situations-to-watch-in-early-2011). Two of these four “uncomfortable situations” are the health of the commercial real estate area and the solvency of commercial banks that fall into the small- and medium-size category.

The small- and medium-sized banks continue to “pull-in-the-carpet.” That is, these banks continue to shrink their balance sheets and they continue to re-allocate assets to either cash or “safe” Treasury securities. They have been doing this for more than two years and show no signs of acting any differently in the near future. To me, this behavior is a real “red flag” that these institutions are not doing well.

And, these smaller banks seem to be getting commercial real estate loans off their balance sheets as fast as they can just re-confirming the problems that exist in this area.

The Federal Reserve continues to pursue the policy they call “Quantitative Easing.” Perhaps a better name for it would be “Keeping the Smaller Banks Liquid.” The reason, I have argued, for keeping the smaller banks liquid is that this allows many of these smaller banks to keep their doors open in the short run so that the Federal Deposit Insurance Corporation (FDIC) can close as many of these banks as they need to in as orderly a fashion as possible. The data continue to support this conclusion.

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?

The Number of Problem Banks Continues to Rise. Surprise!

The most important thing for government regulators at this time is to handle the problems in the banking industry in an orderly fashion. Don’t panic; don’t show fear; just keep plugging ahead.

This seems to be exactly what the FDIC and the Federal Reserve are doing.

The FDIC announced that there are now 829 banks on the problem watch list as of June 30, 2010. Given that 45 banks failed in the second quarter of 2010 this means that 99 additional banks were added to the list. One should note that this figure, 99 banks, compares with 113 banks that were added to the list in the first quarter of 2010. The highest number ever reached for the problem list was 993 and this came in 1993.

Remember, though, that Elizabeth Warren indicated in Congressional testimony that there were 3,000 banks that faced serious problems with respect to loans and assets on their books that probably needed to be written down and that these banks had not seen the full effect of the problems in the commercial real estate sector.

One can also add that these institutions have not really recognized the problems that state and local governments are having in their finances. Note that Pennsylvania’s capital, Harrisburg, announced that it will default on a $3.29 million municipal-bond payment in two weeks making it the second largest general-obligation municipal bond default this year.

With the 32 banks that have failed so far in the third quarter, the total number of failures in the year reached 118, well ahead of the pace from last year when only 140 banks were closed overall.

Using the rule of thumb that one-third of the banks on the problem list will fail over the next 18 months, this would mean that we will experience 276 more bank failures and an average rate of bank failures at 3.5 per week during this time span. In 2010, the pace of bank failures has hovered around this average.

But, the FDIC is working through this tremendous case load in an orderly fashion. There are very few surprises and this is the best thing that can happen given the condition of the banking system.

The Federal Reserve is also contributing to this work out situation in the banking industry. Perhaps the most important thing it is doing is the subsidization of the large banks in the United States. By keeping its target interest rate around zero percent, the Fed is paying a big bonus to the big banks and the payoff for this policy is that the profits at the largest financial institutions have been at record levels and that about 75 percent of the assets of the banking system seem to be well protected.

The profit picture of the banking industry improved in the second quarter with the industry recording the highest level of profits since before the financial crisis. The FDIC reported that nearly two-thirds of United States banks reported a year-over-year improvement. The biggest booster to this performance was the reduction loan-loss provisions.

However, it should be noted that 20 percent of the banks, primarily the smaller banks, reported a net loss and that more than 60 percent of banks, mainly the smaller institutions, continued to increase their loan loss reserves.

Another place where one can find information on the problems the commercial banking industry is having is the report of the Federal Reserve on Enforcement Actions taken by Federal Reserve Banks against some of the financial institutions it regulates.

So far in the third quarter of 2010, the Federal Reserve has engaged in 56 enforcement actions against financial institutions bringing the total up to 192 for the full year to date. Last year only 172 enforcement actions were taken.

Enforcement actions can take one of two forms: a written agreement or a prompt corrective action directive.

The most recent written agreement is a legal action taken by the Federal Reserve Bank of Kansas City, the State of Colorado Division of Banking and First American Bancorp and First American State Bank, both of Greenwood Village, Colorado. This written agreement aims to bring the banks into compliance with every “applicable provision” of the Agreement reached between “the Bancorp, the Bank, and their institution-affiliated parties”, the Reserve Bank and the Division. The agreement specifically deals with Board Oversight, Credit Risk Management, Lending and Credit Administration, Asset Improvement, Internal Audit, Allowance for Loan and Lease Losses, Capital Plan, Earnings Plan and Budget, Liquidity/Funds Management, Dividends and Distributions, Debt and Stock Redemptions, Cash Flow, and, Compliance with Laws and Regulations. The specifics of each of these sections present a very definite list of things the bank(s) must do in order to comply with the agreement. Furthermore, specific dates are given for achieving compliance. And, “The provisions of this Agreement shall not bar, estop, or otherwise prevent the Board of Governors, the Reserve Bank, the Division or any other federal or state agency from taking any other action affecting” the affected parties or this successors and assigns.

The most recent Prompt Corrective Action is that taken against the First Community Bank of Taos, New Mexico. In this agreement very specific actions are required such to “increase the Bank’s equity” and to “enter into and close a contract to be acquired by a depository institutions holding company or combine with another insured depository institution.” The Bank is restricted from making capital distributions or the payment of dividends. The Bank shall not “solicit and accept new deposit accounts, etc.. The Bank shall restrict the payment of bonuses to senior executive officers and increases in compensation of such officers.” And, the bank is restricted in terms of asset growth, acquisitions, branching, and new lines of business.

These enforcement actions are very serious and a reading of some of them can give one an idea of the problems that exist “out there” in the banking industry. And, 192 of these have been given out so far this year!

As more and more information is made available, the more one realizes that the banking industry is being re-constructed. In the next five years or so we will observe a banking industry that is much smaller than the one that exists today and this industry will be even more dominated by the larger institutions making up the industry. I believe that the number of domestically chartered banks in the United States will fall from a present level of about 7,800 banks to around 4,000 banks. I believe that the largest 25 domestically chartered banks in the United States will control about 75 percent of the banking assets in the country up from around 67 percent now.

I am more confident about this latter number than the former one. It is hard to believe that 3,975 banks can profitably be operated when they only control 25 percent of the banking assets. The smaller banks are just not going to be profitable and cannot compete in the world of the 21st century!

"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