Fed Continues to Pump Reserves into Foreign-Reated Institutions in United States

Over the past thirteen week period the Federal Reserve has pumped roughly $350 billion of excess reserves into the banking system. 

From February 2, 2011 to May 4, 2011, cash assets at commercial banks rose by $400 billion.  (Cash assets at commercial banks can serve as a rough proxy for the measure excess reserves.)   

During the same time period, $306 billion of the $400 billion increase in cash assets of commercial banks in the United States went to foreign-related financial institutions.

On May 4, 2011, of the $1,586 billion of cash assets in commercial banks in the United States, 50%, or exactly half of these cash assets, resided on the balance sheets of foreign-related financial institutions.   

The quantitative easing of the Federal Reserve continues to support, in large part, the “carry trade” where funds generated in the United States continue to find their way into foreign markets. 

This is not the first time I have written on this subject: http://seekingalpha.com/article/265481-large-foreign-related-banks-now-hold-776-billion-in-cash-assets.  Actually, this is the third time I have written about the subject: http://seekingalpha.com/article/254004-why-is-most-of-the-fed-s-qe2-cash-going-to-foreign-related-banking-institutions.

Over the past four-week period, cash assets at all commercial banks actually declined by about $9 billion.  However, cash assets at the foreign-related institutions rose by $27 billion during this time period while cash assets at the largest 25 commercial banks in the United States fell by approximately $21 billion and they fell at smaller domestically chartered United States banks by $14 billion.

There is some good news, however!

The good news is that business loans, commercial and industrial loans, at commercial banks really seem to be on the up swing.  Over the past thirteen-week period, C&I loans have increased by $35 billion.  Roughly two-thirds of this increase, or about $23 billion, of the loans came from the largest 25 banks in the country.  However, C&I loans were only up modestly at the smaller commercial banks over this period. 

In the past four-week period business loans were up $10 billion and 60 percent of these, or $6 billion, came from the largest banks.  Again, C&I loans were up at the smaller institutions by a modest amount. 

So, banks, especially the larger banks, seem to be lending again to business, something that is vitally needed if the economic recovery now under way is to really pick up. 

If the goal of the Federal Reserve in conducting QE2 was to get business loans increasing again, then it seems to have succeeded.  Sure, we will have to wait a little longer to get more confirmation of this trend, but this is the first time in this cycle that business loans really do seem to be increasing.

The not-so-good news: the volume of real estate loans on the books of commercial banks continues to tank.  Over the past thirteen-week period, real estate loans at all commercial banks dropped by almost $90 billion.  Over the past four-week period, these loans declined by over $18 billion. 

Almost all of the decline has come at the largest 25 domestically chartered banks in the country.

Over the past thirteen weeks, the major part of the decline came in the area of residential loans ($41 billion), which was closely followed by the fall in commercial real estate loans ($34 billion).  In the past four weeks, the bulk of the decline came in the residential area ($12 billion). 

So, business loans appear to be picking up but the real estate market continues to decline: mixed signals for any sustainable economic recovery.

Maybe, however, this is all the Federal Reserve hoped to achieve at this time.  It seems as if almost everyone believes that it will still be a while before the real estate markets, both residential and commercial, bottom out and start to pick up steam. 

Maybe all the Federal Reserve thinks it can do is to get businesses borrowing again and with that borrowing put some people back to work.  And, it seems that if the Fed can achieve this small win it would think that flooding the rest of the world with United States dollars has been worth it.   

It would be too bad if a substantial part of the uptick in business lending was just going to finance the merger and acquisition activity of large businesses: http://seekingalpha.com/article/269056-the-latest-merger-binge-and-the-economy.   

The Banking System Seems to be Dividing: Large Versus Small

The last three months have seen more and more weakness in the smaller commercial banks in the United States. Last month I ask the question, “Is A Crunch Coming for the Smaller Banks?” (http://seekingalpha.com/article/229385-is-a-crunch-coming-for-smaller-banks)

This month things continued to decline amongst the smaller banks while the largest 25 banks in the country really seemed to expand.

Over the past four weeks ending Wednesday October 27, the biggest 25 banks in the country saw their assets increase by almost $94 billion while the assets at the smaller banks rose by only about $8 billion; but the cash assets at the smaller banks rose by almost $19 billion.

Over the past quarter, the total assets at the larger domestically chartered banks increased by a little less than $20 billion while the assets at the smaller banks actually declined by about $9 billion. Cash assets at the smaller commercial banks rose by over $33 billion during this time.

Loans and leases at the smaller commercial banks have fallen by $14 billion over the last four weeks and by almost $32 billion over the last 13-week period. And, where has most of this decline come from? Commercial real estate loans!

This is, of course, is where many analysts, including Elizabeth Warren, have predicted the trouble would come from until the end of 2011 or so. Warren even stated in congressional testimony that there were some 3,000 commercial banks that were going to face severe problems in the commercial real estate area as these loans either matured and had to be re-financed or went into a delinquent status.

Over the past four-week period, commercial real estate loans at the smaller banks fell by almost $10 billion. Over the past 13-week period, these loans dropped by over $23 billion.

Looking back over the past year ending in September, commercial real estate loans at the smaller commercial banks declined by $74 billion, with half of the decline coming in the last six months.

The decline in assets at the smaller commercial banks is coming exactly where Warren and others warned they would come. But these banks also moved more and more into cash assets during this time indicating a very risk averse position. Over the past thirteen weeks the smaller banks did exactly the opposite of what their larger competitors did: the smaller banks added $33 billion to their cash asset portfolios while the bigger institutions reduced their cash by $30 billion.

The largest 25 banks are still not aggressively pursuing loans. But, their securities portfolios continue to increase. Over the last four weeks, securities held by the largest banks in the country increased by almost $32 billion while they rose by almost $60 billion over the past 13-week period.

This behavior is also exhibited over the last twelve months, ending in September 2010. During this period, large commercial banks increased their securities portfolio by almost $125 billion while their portfolio of Commercial and Industrial loans fell by almost $80 billion and their portfolio of real estate loans dropped by $41 billion.

Some of the financing of these securities came from the cash assets of these large banks which declined by almost $70 billion during this time period. The largest supplier of new funds to these institutions came from something called “Borrowings from Others”. In essence, the larger banks seem to be playing an arbitrage game. They are borrowing short and buying long term securities. The risk to them seems minimal since the Federal Reserve is keeping short term interest rates exceedingly low for “an extended time.” An “extended time” seems to go well into next year.

The largest commercial banks are going to do just fine. They will continue to get stronger and bigger in the future.

The smaller banks continue to struggle. The problem here is that we, the public, really don’t have a handle on how serious the situation is with respect to the solvency of the smaller commercial banks in the banking system.

The “surprise” sale of Wilmington Trust last week took most people by surprise, even the very astute analysts. (See http://seekingalpha.com/article/234027-wilmington-trust-sold-at-45-discount.) Here is a bank known for its conservatism and, in addition, it was solidly producing earnings through its trust department. Yet, the bank had failed to really report the truth about its loan portfolio. Here is a bank, roughly around $10 billion in asset size with bad assets totaling around one billion dollars. How could this happen without someone knowing about it?

How many more commercial banks like Wilmington Trust are out there?

Bankers…lenders…do not like to admit that they have bad loans. In general, they postpone reporting bad loans until it is too late for them…and their shareholders.

Elizabeth Warren said that there were about 3,000 commercial banks in the banking system that were going to face serious strains over their commercial real estate loan portfolio and their construction loan portfolio.

Recent data indicate that large dollar amounts of commercial real estate loans are leaving the balance sheets of the smaller commercial banks in the United States. It would appear as if more and more of these bad assets are being recognized and removed from the banks’ balance sheets.

More and more people are calling for commercial banks to recognize their bad assets so that the United States can start to grow again. I believe that more and more people are realizing that a strong economic recovery is not possible until something is done about these bad assets…until they are written off the balance sheets of the commercial banks.

One of the problems that the Obama team is really going to have to deal with soon is to appoint some people to provide economic and regulatory advice and administration. On the economic side, only Tim Geithner at Treasury and Austan Goolesbee at the President’s Council of Economic Advisors are in place. On the regulatory side connected to depository institutions, only “Bubble” Ben will be in place by the middle of next year. The Office of the Comptroller of the Currency has an acting head. I was at a banking conference last week and there was talk that Sheila Bair, Chair of the FDIC is expected to leave next year and does not want to be re-appointed. The Office of Thrift Supervision is merging into the OCC and the top people are looking elsewhere for leadership. Many leadership positions are empty.

One could almost say there is little or no leadership at the top in Washington, D. C. when it comes to economics and banking.

And yet, 2011 could be a crucial year in American history for determining the future of the structure of the financial system.

Commercial Banking: Still Hanging On

The commercial banking system continues to contract. Loan volumes keep falling.

Total assets in domestic commercial banks in the United States fell again over the past four weeks as the banking system continues to contract. From May 5 through June 2, total assets declined by about $105 billion while Loans and Leases dropped by $48 billion over the same period of time. This is from the H.8 release of the Federal Reserve.

In the past month, Securities held by domestically chartered banks declined by over $42 billion as Treasury and Agency securities at these institutions fell by almost $22 billion and other securities fell by $20 billion.

An interesting aside is that cash assets at foreign-related financial institutions fell by over $54 billion during this four-week period. Institutions took funds from the United States and parked them back in Europe where more liquidity was needed to weather the crisis taking place there.

Splitting this up we find that the total assets of large domestically chartered banks fell by about $86 billion whereas total assets fell at smaller banks by only $19 billion.

Driving this decline was a drop in purchased funds at the larger banks with a fall of $34 billion in borrowing from banks other than those in the United States and from a decline in net deposits due to related foreign bank offices. This would seem to mirror the turmoil taking place in Europe and indicates a reduction in the reliance in funds coming from elsewhere in the world.

Other deposits at these large domestically chartered banks rose by almost $21 billion to offset some of the decline in other sources of funds.

At the smaller banks, deposits continued to run off, declining by about $11 billion while borrowings from banks in the United States also fell, declining by over $5 billion.

Commercial and Industrial Loans (business loans) held roughly constant over the past month although they dropped by about $37 billion over the last 13-week period. Real estate loans continue to drop. They declined by almost $12 billion at the larger banking institutions and fell by over $10 billion at smaller banks. The drop over the past thirteen weeks was about $30 billion.

In addition, consumer loans dropped by over $11 billion at the larger banks over the last four weeks while they stayed roughly constant at the smaller banks.

Year-over-year total assets in the banking system dropped by $256 billion, year-over-year, from May 2009 to May 2010. Loans and leases fell by $222 during the same time period.

Commercial bank lending has declined for more than a year and shows no sign of stopping!

This, of course, is the type of situation that the economist Irving Fisher was worried about when he discussed a debt deflation. Loans that are being liquidated are not being replaced by new loans, hence the decline in loan balances. This is a difficult environment for a central bank. The monetary authority may be injecting funds into the banking system but since banks aren’t lending it feels like the central bank is “pushing on a string.” ( See http://seekingalpha.com/article/209463-the-fed-pushing-on-a-string.)

The concern is whether or not the “lending problem” is a demand problem or a supply problem. That is, if the problem is a demand problem, businesses are not going to their banker to borrow money. If the problem is a supply problem, commercial banks don’t want to make loans.

My belief is that the current dilemma has been created by both sides and this is consistent with Fisher’s concern about debt deflation. In the credit inflation, everyone, banks and non-banks alike, increase their use of leverage. In Fisher’s terms, the granting of new loans exceeds the liquidation of loans so that loan balances increase. In the debt deflation period, loans are being paid down.

And, how is this showing up?

Commercial banks are holding roughly $1.2 trillion in cash assets. Non-bank companies are holding about $1.8 trillion in cash and other liquid assets. This latter number comes from the Wall Street Journal article by Justin Lahart, “U. S. Firms Build Up Record Cash Piles,” http://online.wsj.com/article/SB10001424052748704312104575298652567988246.html?KEYWORDS=justin+lahart.

From the article, “U. S. companies are holding more cash in the bank than at any point on record…” The total of $1.8 trillion is up 26% from a year earlier and is “the largest-ever increase in records going back to 1952.”

The reluctance to borrow/lend is coming from both sides of the market as both banks and non-banks attempt to re-position their balance sheets to protect against further bad times and to be prepared for when the economy really begins to pick up speed once again.

In addition, there is still the concern over the health of the smaller banks in the banking system. The largest 25 banks in the banking system make up about two-thirds of the assets of the banking system. The other 8,000 banks still seem to have plenty of problems. About one in eight of these “smaller” banks are on the problem bank list of the FDIC and between 3.5 and 4 banks have been closed every week this year. This number will probably grow over the next 12 months.

Furthermore, the Federal Reserve continues to keep its target interest rate close to zero. This has been a boon to the larger banks, but is seemingly in place to keep the situation with respect to smaller banks from deteriorating even further. Many analysts believe that the Fed will keep its target interest rate low into 2011. This reinforces my belief that the “smaller” banks in the United States are still in serious trouble. Federal Reserve officials will not confess that the low target rate of interest is to keep as many “small” banks open as possible. To do so would be disturbing to depositors and other customers of these banks.

The question is, are we really in a period of debt deflation? Certainly the loan figures discussed above could be interpreted that way. But, is this all that is going on.

The interesting thing to me is that the economy seems to be bi-furcating in several ways. For one, there are a large number of people that are under-employed and seem to be facing an extended period in which they will be living off of their accumulated wealth, if they have any, or on government welfare. Yet, there are a lot of people that are doing very, very well.

The “big” banks are doing very, very well while the “smaller” banks are scraping by, at best.

The Wall Street Journal article referred to above indicates that businesses, especially larger companies, have a lot of cash on hand and are doing better than OK. We know, however, that there are a lot of other businesses that are not doing so well and still face bankruptcy or restructuring.

One could seriously argue that when the economy really does begin to pick up there will be a tremendous shift in the structure of United States banking and industry. And, if I were to choose, I would bet on the “big” guys! Sorry, little guys!

How Can The Economy Grow Without Bank Loans?

The economy seems to be picking up steam, yet bank lending does not seem to be keeping pace. Also, money stock growth does not give off positive signals in terms of how people are allocating their short-term assets in the banking system.

The question is: can the economy continue to pick up if people are staying very conservative in terms of their asset allocation in the banking system and the banks, themselves, continue to stay out of the lending market?

Overall, the total assets in the banking system (according to the H.8 release from the Federal Reserve System) have only grown modestly in recent months, up 1.3% from March to April at all commercial banks in the United States, with large banks (the twenty-five largest banks in the United States) showing a 2.1% rise and all other banks increasing at a 1.0% rate.

Over the past year Total Assets at all commercial banks are down by -1.5%, decreasing by 0.8% in the largest banks and rising 1.0% in the larger banks.

The problem with this is that the rise in the last month is due to a reporting change in the banking system and is not the result of real growth. On March 31, banks were required to bring a substantial amount of securitized loans onto their balance sheets from being accounted for as memoranda items.

The vast majority of this movement was connected with consumer loans. Thus we see that from March to April consumer loans at all banks rose by slightly more than 31%. The largest banks saw the greatest change, rising over 35%, while the smaller banks consumer loan accounts rose by slightly more than 17%.

The thing is, consumer loans are not increasing. The increase is coming solely fromt the change in the accounting for these securitized consumer loans.

All other loan classifications rose by much smaller amounts over the past month but actually declined over longer periods of time.

For example Commercial and Industrial loans, business loans, at all commercial banks rose by only 0.6% from March to April. They are actually lower over the past three months, down 4.0% and down 18.0% year-over-year.

Commercial banks are just not lending to businesses! And, this is across the board, in both the biggest 25 banks in the country and all the rest. Over the past year Commercial and Industrial Loans at large commercial banks dropped by over 19% while this same category of loans at small banks dropped by almost 9.0%

Real Estate loans have not fared any better. Up only modestly in the past month, these loans have declined for the past three months, the past six months and the last 12 month. Again, Real Estate loans at the biggest 25 banks have declined by slightly more than 2.0%, year-over-year, and they have declined by a little more than 4.0% at the smaller banks.

Shall we take these modest increases as a positive start to the increase in bank loans? Well, one month does not make a trend. We need to keep watching the banks to see if loan volume is increasing giving us some feel that not only loan demand is rising, but that the banks are actually lending again.

Cash assets at all banks declined over the past month. Whether this was a response to the Treasury’s use of their Supplemental Financing Account at the Federal Reserve (See my posts: “Federal Reserve Exit Watch Part 10”, http://seekingalpha.com/article/202476-federal-reserve-exit-watch-part-10; and “The Fed’s New Exit Strategy?”, http://seekingalpha.com/article/199444-the-fed-s-new-exit-strategy.) or the portfolio behavior of the banks themselves, there was a fairly sizeable drop in cash asset at all commercial banks.

Still over the past three months cash asset rose at both the biggest banks and the smaller ones. Again, the direction the banking system is taking with respect to excess reserves is still unclear. All one can say is that they have declined recently.

The banking system is still facing the fact that people are continuing to move their assets into the banking system and primarily into transactions accounts. This is seen by the fact that the M1 measure of the money stock has risen by almost 7.0%, year-over-year in April while the M2 money stock measure has risen by only about 2.0%. Thus, since there is almost no growth in the M2 measure of the money stock, there must be a substantial amount of shift between the non-M1 portion of M2 to the M1 measure.

In fact the total non-M1 M2 has risen by only 0.4% from April 2009 to April 2010.

As I have argued many times before, this is very conservative money management on the part of asset holders. People are putting their funds into transactions accounts so that they have them for spending. They are removing funds from non-transaction accounts which are less liquid and, with interest rates so low, not worth the effort of keeping their funds in these accounts.

This movement is also picked up in the decline in Retail Money Funds which have dropped almost 28%, year-over-year, and Institutional Money Funds which have dropped about 23%, year-over-year. These declines have continued at rapid paces for the last three months and the last month as well!

The efforts of the Federal Reserve are not being translated into bank loans or money stock growth. Monetary policy is not being translated into assets that support economic growth!

People and businesses are still in a defensive mode with respect to their asset management!

The Great Recession is over and the recovery has begun. Yet, the statistics coming from the banking system do not promote a lot of optimism. This is consistent, I believe, with consumers that are still reeling from being unemployed and losing their homes and with a banking system that is not out-of-the woods in terms of solvency issues (except for the largest 25 banks, of course.)

Strong recoveries are usually connected with strong growth in bank loans and the various measures of the money stock. Especially important is an increase in commercial and industrial loans…business loans. This is not happening.

From all we see the large banks are making a “killing” being subsidized with extraordinarily low interest costs. We learned last week that many large manufacturing and industrial business firms are sitting on huge amounts cash and other assets ready to “make a killing” when things do start to pick up. The big guys are in great shape!

If anything the financial collapse, the Great Recession, and government policy have done for big business what they could not have done for themselves. The transfer of wealth in America is going to be huge in the next five years or so thanks to Bush 43 and Obama 1. Greater wealth inequality…here we come!

Financial Reform Is No Silver Bullet

These days I find it very hard to be on the same side of arguments with Paul Krugman. I must admit that today I am mostly in agreement with what Krugman has written in the New York Times. (“Georgia on My Mind”, http://www.nytimes.com/2010/04/12/opinion/12krugman.html?hp.)

To begin with, Krugman asks the question: “What’s the matter with Georgia?” He raises this question because that Georgia has recorded 37 bank failures since the beginning of 2008 against 206 for the nation as a whole.

Why is Georgia different?

Georgia, he contends, was not a part of the housing bubble that saw home prices soar to the point that upon the collapse of prices, many home owners found themselves in a position of negative equity. Unlike many other states, Georgia had lots of land and few limits on expansion into empty spaces. As a consequence, Georgia, and especially Atlanta, did not see much of a rise in housing prices.

Still Georgia managed to create its own housing problem. Krugman states that “the share of mortgages with delinquent payments is higher in Georgia than in California” and “the percentage of Georgia homeowners with negative equity is well above the national average.”

The problem? “Georgia suffered from a proliferation of small banks.” And, these small banks were anything but conservative. “Actually, the worst offenders in the lending spree tended to be relatively small start-ups…”

These banks did not develop local deposit bases but relied on “hot money” from out-of-area investors. Their lending practices? New mortgage loans, subprime loans, and home-equity loans. Anything they could put on the books to generate fees and cash flows.

The prices of houses did not rise by as much in Georgia as they did in other states, yet the equity that people had in homes fell, and fell, and fell.

Krugman contends that the reason for this was the absence of consumer-protection regulation so that people could use their homes as “piggybanks” and almost continuously extract cash by increasing the size of their mortgages. He contrasts this behavior with Texas that also had lots of land and few limits on the expansion into empty spaces. Texas avoided the mess that Georgia found itself in because, according to Krugman, Texas had consumer-protection regulation.

This is where I differ slightly from Krugman in interpretation. To me the problem is that “Georgia suffered from a proliferation of small banks.” Too many banks were chartered to serve too limited a geographic area. The competition for loans was too great for the area. Real estate construction was expanding because it could get financed. People could continue to borrow because banks needed to push out money. The government was happy because more Americans were owning their own homes.

This was all a part of the general credit inflation of the past twenty years as more and more debt was created to support the movement of into housing. It came from an unlikely place: commercial banks.

If you would go back in history and ask bankers from the 1960s whether or not commercial
banks should hold more than 60% of their loan portfolios in real estate loans, you would have gotten an overwhelming vote of “NO!”

If one looks back at the 1960s, one finds that, for example, all domestically chartered banks held only 25% of their loan portfolios in mortgages or other real estate loans. Looking at the same figures for 2009 we find that all domestically chartered banks held 61% of their portfolio of loans and leases in mortgages or other real estate loans.

Commercial banks used to lend primarily to businesses. That is why they were called “commercial” banks.

Now domestically chartered commercial banks hold three-quarters of their loan portfolios in real estate loans and consumer loans.

We get a split according to size as well. Small commercial banks now hold almost 70% of their loans and leases in mortgages and real estate loans. The largest 25 domestically chartered commercial banks in the United States hold roughly 55%.

The largest banks hold 17% of their loan portfolio in consumer loans whereas the loan portfolios of smaller banks only contain about 9%. Adding the two numbers together results in both the big banks and the smaller banks holding around 75% of their loans in these categories.

Commercial banking has changed!

Since the 1960s, the mortgage market has become the place where commercial banks play. This is even more so for the smaller banks! And, Georgia represents our extreme example of this.

How did we get to where we are? A picture of this transition from the 1960s to now is presented by Michael Lewis in his book “Liar’s Poker”. The first mortgage pass-through security was issued in 1970. By the middle of the 1980s the mortgage market was the largest component of the capital markets worldwide. Lewis describes this part of the capital markets in his book.

I do agree with Krugman that some consumer-protection regulation is important in this world. But, it is not a panacea. And, along with other regulation of financial institutions it is not a “silver bullet” that will keep the United States from another financial crisis in the future.

We are hearing almost daily the things that the larger commercial banks are doing to avoid future regulation. Plus, it is my contention that these banks have moved well beyond what Congress is now working on to resolve financial crises. Furthermore, we are constantly bombarded by headlines like the one that appeared in the Financial Times this morning, “Banks seek to exploit new rules,” http://www.ft.com/cms/s/0/b6e57828-4588-11df-9e46-00144feab49a.html.

And, as Krugman argues, “The case of Georgia shows that bad behavior by many small banks can do as much damage as misbehavior by a few financial giants.” Of the 8,000 small- to medium-sized banks in United States, about one in eight is seriously in trouble. This certainly is not the major part of the pie as these 8,000 or so banks make-up only about a third of the assets of domestically chartered commercial banks in the United States. The largest 25 banks control two-thirds of the banking assets in the country.

Conventional regulation is not going to do the job in this information age. (See my comments on this beginning with http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.) I have found a regulatory scheme I believe will work better than the ones currently being proposed. I will write on this scheme later this week.

Banks Remain on the Sidelines

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

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

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

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

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

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

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

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

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

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

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

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

Banking Sector Still Remains Silent

There is good news and bad news from the banking sector. The good news is that all is quiet. The bad news is that all is quiet.

In terms of the goods news, “quiet is good” because there have been no new “discoveries” of bad loans or bad assets that will shock the financial system. We continue to hope for silence here even with the continued growth in the unemployed, in bankruptcies, in delinquencies, and in loans coming due that need to be re-priced or re-financed.

In terms of the bad news, there is still no life in bank lending. If we are going to see a pick-up in the economy and a return to growth the banking sector is going to have to start lending again, especially in the commercial sector. Commercial and industrial loans were down by 3.3%, year-over-year in June, and in the last five weeks, all in July, these loans have fallen by another $24 billion.

Real estate loans peaked in May 2009 and have declined ever since, dropping approximately $60 billion through the end of July. Even the amount of home equity loans has declined steadily since reaching a peak in May. Consumer loans continue to drop, with credit card debt falling for the fifth consecutive month.

Total bank assets are still up on a year-over-year basis by 7.5%, but the main balance sheet increases are in cash assets, primarily deposit balances at Federal Reserve Banks, and in Treasury and agency securities.

Banks are still not doing any lending to speak of and are staying very, very liquid.

On the liability side of commercial bank’s balance sheets, demand deposits are still rising at a very rapid pace, about 38% on a year-over-year basis. Other checkable deposits at commercial banks are rising at a relatively rapid pace, 19.3%, but a surprising bit of information is that other checkable deposits at thrift institutions have only increased by a modest amount, by 2.9%, year-over-year.

Checking into the thrift institution situation a little further we find that savings deposits at thrift institutions have actually declined year-over-year at a 7.9% rate and small-denomination time deposits at thrift institutions have fallen at a 14.3% rate over the same time period. These balances at commercial banks have increased at a 16.3% rate and a 15.3% rate respectively.

Two shifts seem to be taking place in depository institutions. First, there seems to be a major movement of funds from thrift institutions to commercial banks. Second, individuals are holding more and more of their funds at commercial banks in demand or other checking accounts relative to time and savings accounts. One additional note to this: retail money funds have dropped by about 11.6% on a year-over-year basis indicating another shift taking place from non-banks to commercial banks.

Another trend continues to hold and that is in terms of currency holdings outside of the banking system. Year-over-year, the currency component of the money stock continues to rise in excess of 10%. Like the banks, the public wants to remain as liquid as possible in order to be able to meet the contingencies people experience in uncertain times.

This movement of assets is reflected in the aggregate money stock figures. The Fed publishes money stock growth figures using 13-week averages. On a year-over-year basis using the thirteen weeks ending July 27, 2009, the narrow measure of the money stock, M1, has increased at a 17.0% annual rate whereas the broad measure of the money stock, M2, has increased at an 8.7% annual rate. It is obvious that the growth rate of both measures is dominated by the huge annual rate of increase in demand deposits as people have re-allocated their funds from time and savings accounts to checkable deposits in commercial banks.

This shift is even more obvious if one looks at the relative rates of growth over the past three months. M1 growth is 15.4% while M2 growth is 3.1%, indicating that much of the re-allocation of funds has come in the past three months.

In terms of the Fed’s assets, there continues to be a runoff of dealers using the Commercial Paper funding facility indicating some easing of liquidity in the commercial paper market. This decline was expected to occur as the commercial paper market improved and this is a hopeful sign. Central bank liquidity swaps also continued to decline indicating an additional strengthening of foreign exchange markets around the world, another hopeful sign.

Both of these declines in the Fed’s balance sheet resulted in reserves leaving the banking system. All it means, however, is that excess reserves in the banking system declined. These excess reserves still remain well above $725 billion, while required reserves total around some $65 billion.

As reported before, the banking system seems to be coming out of the big financial bust in typical fashion. This is why the claim that things are quiet in the banking system is a good thing. We can only hope that this peace and quiet will continue.

There will continue to be bank failures. We reached 72 for the year this last week, but there were no surprises in the increase, they had already been identified. One concern arising from the figures presented above is the health of the thrift industry. With funds leaving the thrift industry as reported, what pressure is this putting on thrift institutions in terms of their assets and solvency?

The big question remains: “When are the commercial banks going to start lending to businesses again?” To answer this, we need to keep a close eye on the information coming out of the banking sector. My guess is that banks will not be too quick to start lending to businesses again. There are questions about how brisk the “back-to-school” season will be and there may not be much increase in lending during this time. The next really big test after that will be the holiday season that begins in October and early November. It will be interesting to see how lending activity behaves at this time.

The Fed continues to keep funds going into the capital markets in terms of acquiring Treasury securities and mortgage-backed securities while letting some of the other facilities that were created to support liquidity in different specific areas of the financial markets run off as it was hoped that they would do. As long as the banking sector remains relatively peaceful, this seems to be the way the Fed wants to act. Then as liquidity picks up in the stressed areas of the capital market, the Fed plan is to sell these other securities back to the private sector and reduce the size of its balance sheet.

The good news in the banking sector is that things are relatively quiet. May they stay that way. In my view we will have to wait a while before we see the banks beginning to refuel businesses and the real estate sectors.