Why Banks Aren't Lending

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

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

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

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

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

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

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

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

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

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

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

Is there a problem here?  You betcha’!

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

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

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

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

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

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

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

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

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

United States Loses 355 Banks in 2010

One December 31, 2010, the FDIC reported that there were 7,657 insured depository institutions in the United States. This was 355 less than the 8,012 institutions that were in existence on December 31, 2009. (157 banks were officially closed by the FDIC in calendar 2010.)

This is up from the 293 institutions that dropped out of the industry in 2009.

In the fourth quarter of 2010, the number of insured depository institutions in the United States dropped by 104 depository institutions.

The number of banks on the FDIC’s list of problem banks rose from 860 to 884 at the end of the year.

The FDIC does not list how many of these problem banks went out of business in the fourth quarter of 2010 or were acquired by or merged into other institutions during this period. But, the picture is not quite as rosy as New York Times columnist Eric Dash reports this morning: “And only 24 lenders were added to the government’s list of troubled banks, the smallest increase since the financial crisis erupted in late
2007.” (http://dealbook.nytimes.com/2011/02/23/banking-shows-signs-of-a-turnaround/?ref=business)

Most of the banks leaving the banking industry were on the smaller size.

Furthermore, the list of problem banks does not include many other banks that are facing serious problems but have not yet qualified to be put on the FDICs list of problem banks. Need I mention the name of Wilmington Trust Bank, a bank that was considered by almost everyone as a bank that was doing OK. Then came the news of its sale last November. (http://seekingalpha.com/article/234027-wilmington-trust-sold-at-45-discount)

The problem list is a proxy for the number of institutions that are severely stressed, but does not include all that are still experiencing questionable futures. These latter banks have just not crossed the statistical threshold to be considered “problem banks.” Still 12% of the banking system is on the problem list.

I have been arguing for more than a year now that the actions of the Federal Reserve have been aimed at keeping things calm in the banking industry so that the FDIC can close or arrange acquisitions for troubled banks in an “orderly” fashion. This, I believe, has been one of the reasons that the Fed’s target interest rates have been kept near zero for such a long time. It is also part of the reason for the Fed’s second round of spaghetti tossing, or, quantitative easing (QE2).

The FDIC has needed the calmest environment possible to oversee a dramatic reduction in the number of banks in the banking system. As reported above, the banking system has almost 650 fewer banks in existence now than were in the banking system on January 1, 2009. That is a reduction of almost 8% of the banking institutions that existed at that time.

The other fact that does not bode well for the smaller banks in the country was just reported by the Associated Press: the profits of the big banks represented 95% of all bank profits in the fourth quarter of 2010. The big banks earned $20.6 billion of the $21.7 billion in profits earned by the banking industry as a whole. That is, only about 1.4% of the 7,657 banks noted above with assets of more than $10 billion saw these earnings.

And, bank lending. Bank lending continues to drag. I reported in my post of February 21, 2011:

“bank lending was abysmal over the past 6-week period and the last 14-week period.

Since the end of the year, loans and leases at the largest 25 domestically chartered banks in the United States dropped dramatically by about $50 billion, much of this coming in consumer lending although loan amounts were down across the board. Loans and leases held roughly constant in the eight weeks that preceded December 29 at these large banks.

In the rest of the banking system, the declines in the loan portfolio came primarily before the end of the year. After falling by about $60 billion in November and December, loans at these institutions rose slightly in the first six weeks of 2011. Notable decreases came in both residential lending and in commercial real estate loans, each declining by a little more than $20 billion over the last 14-week period.” (http://seekingalpha.com/article/254004-why-is-most-of-the-fed-s-qe2-cash-going-to-foreign-related-banking-institutions)

My question still remains, “why should the commercial banks be lending?” A large number of the banks have balance sheets that are not in very good shape, interest rates are abysmally low, and there are still quite a few sectors of the economy, housing, commercial real estate, consumer loans, state and local governments, that are experiencing serve financial difficulties themselves.

Having $1.2 trillion of excess reserves in the banking system is not justification for the banks to be lending…especially the smaller banks.

If the banks don’t lend right now it avoids the possibility of putting another bad loan on their balance sheets. In that way they can focus on their existing bad loans.
Some people looking for “green shoots” in the banking industry claim that they have found them. Unfortunately, I have not yet found a lot to raise my spirits.

The Number of Problem Banks Rise in the Third Quarter

The number of problem banks, as listed by the FDIC, continued to rise in the third quarter of 2010. The number went from 829 at the end of the second quarter to 860 in the third quarter.

Forty-one banks failed in the third quarter, an average of about 3.2 banks per week. A total of 149 banks have been closed through the first three quarters of 2010, an average of 3.8 per week. Thus, the pace of bank closings has been relatively steady throughout the year, somewhere between 3 and 4 banks per week.

The total number of FDIC-insured commercial banks in the system was 7,760 at the end of the third quarter. This is down from 7,830 at the end of the second quarter and 8,195 at the end of the second quarter of 2009. So, the number of banks in the system dropped by 70 banks in the third quarter. Since June 30, 2009, the number of banks in the system has fallen by 435.

The decline in the number of banks in the banking system is not all failures as some banks are merged into other banks before the bank is closed by the FDIC. For example, in the third quarter of 2010, 30 mergers took place.

So, the industry is shrinking by bank failings and by the consolidation of healthy banks with banks that are not in very good shape. From June 30, 2009 to June 30, 2010, the number of banks in the banking system dropped by 365 banks, an average of 7 banks per week. In the third quarter of 2010 the number of banks dropped by 70 banks, an average of about 5.5 banks per week.

This fact raises concerns not only about those banks that are listed on the problem list, but what about those banks that are in serious trouble but do not “qualify” to be on the FDIC’s problem list?

How many surprises are out there?

Wilmington Trust, in Wilmington, Delaware, was considered to be doing OK. Then, the bombshell hit. Wilmington Trust ended up being sold at a 45% discount. (See http://seekingalpha.com/article/234027-wilmington-trust-sold-at-45-discount.)

How many more banks in the system are facing the same fate as Wilmington Trust?

Earlier this year Elizabeth Warren told Congress that as many as 3,000 commercial banks were facing real problems over the next 18 months.

My prediction is that the total number of banks in the banking system will drop to 4,000 or so over the next five years. This is down from 7,760 at the end of the third quarter of 2010, a reduction in the number of banks of 3,760 banks or of approximately 750 banks per year for the next five years.

There is good news:
“Banks and savings institutions earned $14.5 billion in the third quarter, $12.5 billion more than the industry’s $2 billion profit a year ago, the FDIC said yesterday. The third-quarter income was below the $17.7 billion and $21.4 billion reported in this year’s first and second quarters, but agency officials said the shortfall was attributable to a huge goodwill impairment charge at one institution.

A reduction in loan-loss provisions was the primary factor contributing to third-quarter earnings…. While third-quarter loan-loss provisions were still high, at $34.3 billion, they were $28 billion -- or 44.5 percent -- lower than a year earlier. Net interest income was $8.1 billion -- or 8.1 percent-- higher than a year ago, and realized gains on securities and other assets improved by $7.3 billion, officials said.”

This was from the American Bankers Association release, “Newsbytes”.

But, the good news was not for all sectors of the banking industry. As I have been reporting in my posts, the largest twenty-five banks continue to prosper at the expense of the smaller banks. One must report that the “good news” presented above is for the industry as a whole. For the largest twenty-five banks, the news is “good”. For the other 7, 735 banks…the results are really “not-so-good”.

And this is why the worry is focused on the smaller banks.

We keep getting bits of news like that reported in the NYTimes this morning, “Large Banks Still Have a Financing Advantage” (http://www.nytimes.com/2010/11/24/business/24views.html?ref=todayspaper):

“What happened to ending ‘too big to fail?’ That was one objective of the financial overhaul bill, the Dodd-Frank Act, that was passed this year. Central to the legislation were rules intended to make big banks less exciting and safer. It also created an authority meant to smoothly wind down even the largest institutions without greatly disrupting the financial system.

Five months after the bill’s passage, big banks should have lost at least some of their financing advantage over smaller rivals. But as the latest quarterly report from the FDIC shows, too big to fail is still very much alive and well.”

The point being made is that the average “cost of funding earning assets” for commercial banks in excess of $10 billion (109 banks out of the 7,760 banks in the system) was 0.80 percent. The average cost of the 7,651 smaller banks was an average of 1.29 percent so that the bigger banks had a 49 basis point advantage over the smaller banks. (Note that the gap was 69 basis points a year ago.)

The average cost of funding earning assets was even lower for the largest 25 banks in the country!

It seems like everything the policy makers are doing is benefitting the largest banks in the country.

And, what is being done for the smaller banks…the other 7,735 banks?

The Federal Reserve is pumping plenty of liquidity into the banking system so that the FDIC can reduce the number of banks in the banking system as smoothly as possible. (See my post “The Real Reason for Fed Easing”: http://seekingalpha.com/article/237834-the-real-reason-for-fed-easing-debasement-inflation.)

In reducing the number of banks in the banking system we don’t want disruptions and we don’t want panic. If this is the goal of the Federal Reserve and the FDIC, then they are doing a good job. The bank closure situation has, so far, neither resulted in major disruptions to the financial system or the economy or panic over the state of the banking industry.

The dismantling of the former United States banking system is going quite smoothly, thank you.

The future United States banking system is going to look entirely different. What might that banking system look like? Try the Canadian banking system or the banking system in Great Britain…a few very large banks dominate these systems. Is that what the United States system is going to look like?