JUST HOW SOUND IS THE BANKING SYSTEM / SEEKING ALPHA

Just How Sound Is The Banking System?
     

by: John M. Mason          

       

Summary

 

- Standard & Poor's is downgrading eight of the largest banks in the United States, but this also raises questions about the rest of the banking system.

       

- Banks have not lent during this economic recovery the way they have in past recoveries and many are holding onto substantial amounts of excess reserves.

       

- Furthermore, the number of banks in the banking system continue to drop by over 200 a year with the greatest number of losses being community banks.

       

In the normal economic recovery, commercial banks usually play a significant role. In the current economic recovery, now almost six and one-half years old, commercial banks have been noticeably quiet.

This should be of concern to analysts looking for a stronger recovery. Perhaps the banking industry is not in as strong a position as many people have thought. Maybe, the banking industry is still facing problems that are not totally recognized.

After almost six and one-half years into the economic recovery and we get the news that Standard & Poor's is downgrading eight of the biggest banks in the United States.

Yes, Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C), and Wells Fargo (NYSE:WFC) were downgraded. And, Globally Systemically Important Banks, GSIBs, Morgan Stanley (NYSE:MS), Goldman Sachs (NYSE:GS), Bank of New York Mellon (NYSE:BK), and State Street (NYSE:STT), have also been downgraded.

Under new rules to deal with banks that are "too big to fail," regulators will require that "Banks are expected to hold total loss absorbing capacity - TLAC - of at least 18 per cent of their risk-weighted assets."

"In October the Fed(eral Reserve) projected that the six largest banks faced a $120bn capital shortfall under new rules that would require the institutions to hold big buffers of debt that could be converted into equity in a crisis."

Standard & Poor's sees this shortfall as significant and puts the banks under pressure to eliminate the shortfall. So maybe the banking system is not as healthy as has been believed.

European banks certainly have a lot of work to do as well. The European Banking Authority has just released information that European banks are still facing about €1 trillion (or $1.06 trillion) of bad loans. The report indicated that bankers were continuing to build up their equity reserves, but still had a long way to go.

And, Mario Draghi and the European Central Bank has just "extended and expanded" its round of quantitative easing, the round that began earlier this year. The rationale for the addition is that the growth of the eurozone has not been what has been desired and that the ECB would like European inflation to move up closer to what the central bank would desire.

But, maybe one of the goals of the ECB is to keep banks open so that they can work out their problems without direct regulatory help.

This is one thing that I have written about concerning the quantitative easing efforts of the Federal Reserve. One of the objectives of former Fed Chair Ben Bernanke was to provide sufficient liquidity to the banking system to keep banks open and avoid the number of bank failures reaching levels experienced during the Great Depression.

Mr. Bernanke's policy of pumping reserves into the banking system to keep things afloat will, I believe, be his greatest legacy. During the Great Recession and subsequent recovery, Bernanke's policy was to "throw enough 'stuff' against the wall to see how much will stick."

The fact that outright bank failures were so low was a tribute to the success of his policy.

But, the growth of bank lending during the economic recovery has never come close to achieving levels attained in earlier recoveries, and this is while the banking system has been sitting on over $2.5 trillion of excess reserves.

Furthermore, over the past several years, even though this time period was well into the economic recovery, the banking system continued to lose more than 200 commercial banks per year.
The reduction in the number of banks in the system, however, has not occurred through outright bank failures, but through bank mergers and acquisitions.

This decline in the number of banks outstanding has been done in a calm and constructive way, under the oversight of a regulatory system that wants to see the number of banks in the system decline, but without disruptions and dislocations.

In this, I believe that the regulators have been very successful in their efforts, but have benefited greatly from the presence of all the liquidity supplied to the banking system by the Federal Reserve.

On September 30, 2015, there were 5,410 banks in the United States. At the beginning of the Great Recession, December 31, 2007, there were 7,219 banks.

Of further interest, at the earlier date, there were 3,064 banks whose asset size was $100 million or less. On September 20, 2015, the number of banks of this size had fallen to 1,542.

In other words, the smallest banks in the United States, the heart of the country's community banks, have declined by roughly 50 percent over the past eight years!

So, just how healthy is the commercial banking system? Maybe the health of the banking system is one of the reasons why the US economic recovery has been so disappointing.

Furthermore, maybe banking systems that are not so healthy is one of the reasons why the European economic recovery has been so disappointing.