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There are three preliminary indicators that the banking system is coming along on its way to recovery. First, there is the “letting go” of CIT Group, Inc (NYSE:CIT). The government must feel that it does not need to extend itself to help out this institution given its present troubles. (See my recent post on the CIT situation.) We’ll see if they continue this approach with other troubled institutions as additional situations arise.

Second, there is evidence that the regulators are taking a harder line at Bank of America (NYSE:BAC) and Citigroup (NYSE:C). Each has its own problems, but the Feds seem to believe that they can step up their demands on these two financial institutions concerning boards, managements, business affairs, and so forth. They would not do this if they believed the system to be too fragile.

Third, I sense the Federal Reserve backing off from the more aggressive stance it took with respect to the bond markets one to two months ago. This is just a feeling that I will be following up on in the near future.

These actions provide some preliminary evidence that we are in the “working out” stage of the credit cycle where time is the biggest factor to contend with. Bailouts are needed to prevent “liquidity” problems when markets might crumble under cumulative selling pressures. But, this is a short run problem.

The “work out” phase of a financial crisis is the period when institutions still have severe credit problems but are not under short term pressures to relieve their balance sheets of “toxic” or “underwater” assets.

This does not mean that there will not be more failures of financial institutions and some of them may be relatively large ones. What it does mean is that the problems that still exist within the financial sector can be handled in a relatively orderly fashion. So, the banks and the regulators can operate within an environment that does not seem “desperate.” Severely troubled still, but not in a state of panic.

Within this scenario, the questions that remain about the banking system relate to earnings. We have seen Goldman Sachs (NYSE:GS) and JPMorgan Chase & Co. (NYSE:JPM) post strong gains for the second quarter. However, most of the gains were attributed to trading activities, with secondary help from their underwriting business. These are not good, solid “banking” results. And, these organizations are highly diversified and can post returns from these areas, something that most other banks in the United States cannot do.

Still, the banking system seems to be in the stage of recovery where current cash flows can allow the individual banks to write off more and more of their loans and other assets over time and thereby restore the integrity of their balance sheets. With the results it achieved in trading and underwriting, JPMorgan Chase was able to take large write downs of home equity loans, mortgage defaults, and credit card charge offs while also increasing the amount of funds it set aside to increase its loan loss reserve. This is what other banks will be doing to reduce the burden of bad assets they are now carrying.

Overall, Total Assets in the commercial banking system grew by 8.9% from June 2008 to June 2009. The capital residual (Assets less Liabilities) in the system grew by 7.6% so that the capital asset ratio of the banking system dropped from 10.2% to 10.1%.

In terms of how the banks are attempting to protect themselves, the Cash assets of Commercial Banks in the United States were up 186%, year-over-year, in June 2009, although this rate of increase is down from a year-over-year rate of increase of 236% increase in May 2009.

Total Loans and Leases in the banking system rose just about 1.4%, year-over-year, in June while Commercial and Industrial Loans actually decreased by 3.1%. Commercial banks are just not lending to businesses which continues the trend which began last year. Banks are lending to consumers, up 5.5% year-over-year (primarily on credit cards and other revolving credit plans), and on real estate, up 6.4% year-over-year (the largest jump coming in revolving home equity loans).

The cash assets held in the commercial banking system declined regularly throughout June as the peak in cash assets held was reached in May. Thus, it appears that banks are backing off from taking everything the Federal Reserve has put into the banking system and stashing it away in “cash accounts”. This is confirmed by the aggregate banking data put out by the Federal Reserve which indicates that total reserves in the banking system dropped throughout June 2009 and the excess reserves also fell from peak levels reached in late May.

Thus, it appears that things are working out pretty much as the Fed hoped they would. (See my explanation of what the Fed has been trying to do,) Of course, the game is not over yet!

Bottom line: the banking system is working through its problems. The Federal Reserve and the regulators seem to be backing off a little, allowing the system to adjust over time to its dislocations. There is still room for a surprise, but, the more time passes, the less likely a surprise is likely to occur. In other words, the unknown unknowns have been substantially reduced and the known unknowns are what we are working on.

The banks are not lending except on established credit lines (credit cards and home equity loans) and there appears to be plenty of liquidity in the system as a whole. Whereas the lack of lending slows up the possibility for an economic recovery, it is an essential component of getting the banking system healthy again which is needed if there is to be any chance of a robust economic recovery in our future.

Source: The State of the Banking System