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I have argued over the last few years and in my recent post "The Economy in 2014: How is All the Cash Being Used" that one of the reasons the Federal Reserve had supplied all the bank reserves to the banking system in recent years was to provide sufficient liquidity for troubled banks so that they could stay open long enough to work out the bad assets that still remained on their balance sheets or so that they could be acquired in an orderly manner and absorbed into other, more healthy banks.

I knew that even in 2013, the banking system was not out-of-the-woods yet in terms of the solvency of many, many banks. I just had to wait until more and more evidence came to light in order to justify my claims.

Some of that evidence is now surfacing. I will present two pieces of this evidence in this post.

The first bit of evidence has come to light with regards to a lawsuit from the American Bankers Association. The lawsuit relates to the impact that the imposition of a provision of the "Volcker Rule" might have on "smaller" commercial banks in the United States.

The specific provision of the Volcker Rule has to do with how collateralized debt obligations (CDOs) backed by trust-preferred securities are treated. Many banks issued these CDOs before the financial crisis and many other banks purchased these CDOs because of their favorable capital treatment and the promise of steady interest payments.

Many banks flocked to these securities during the credit inflation and financial innovation of the past 20 years in order to take on more risk so as to gain higher returns without threatening their capital positions. Bigger banks pushed these securities down to smaller and smaller institutions as the credit "dance" heated up.

The lawsuit stated that "275 small banks would suffer an imminent $600 million hit to capital" if a certain provision of the Volcker Rule was imposed on all banks in the banking system. This quote is from the New York Times.

A definition of "small" banks was not provided.

Let it be noted that the problem under discussion gained national attention when Zions Bancorporation, a regional banking organization headquartered in Salt Lake City, Utah, stepped up on December 16 and said that it was taking a $387 million charge to write down the value of a portion of its portfolio that would be impacted by the new Volcker rule. Zions Bancorp is not considered to be a "small" bank as it has $55 billion in assets. Note that it's write down equals about two-thirds of the write downs that would be taken by the 275 small banks referred to in the ABA lawsuit.

Two points need to be discussed: first, the FDIC statistics show that there are only 1,875 banks that are less than $100 million in asset size and 3,523 banks that have assets in the $100 million to $1 billion range. If these banks are considered to be "small" banks, then the 275 banks represents a little more than 5 percent of the "small" banks.

Second, if banks like Zions, with assets in excess of $1 billion, are not considered to be in the "small" bank category, the question then becomes, how many of these "larger" banks face a possible write down because of this provision in the Volcker Rule? In addition, what might be the write down these "larger" banks have to take?

Further evidence of commercial bank asset problems is addressed in the Financial Times. The specific situation addressed is that relating to the distressed debt of many lenders in Europe. It seems as if the time has come when European banks and other financially-related organizations are able to sell some of their worst-performing loans to "distress investors"…many of them being American.

It seems as if, "until recently, banks, under pressure to boost regulatory capital, could not afford to crystallize the losses involved when selling impaired loans." Anne-Sylvaine Chassany and Henny Sender write in another piece in the Financial Times, "Many of the lenders have now been recapitalized and are accelerating asset disposals, according to private equity investors.

This is a usual occurrence following periods of economic distress, but the timing this time around is somewhat unusual. Chassany and Sender quote Viktor Khosla, founder and chief investment officer of Strategic Value Partners: "Normally five years after a crash like in 2008, pipelines of distressed deals keep shrinking. I've been doing this for 20-odd years and it's the first time I find that, between year three and year five, our pipeline has so dramatically surged."

It seems that this time around that the banking system was in such dire straits that it had to reach a certain level of liquidity and stability before the banks could consider selling the assets because of the deep discounts that had to be given…sometimes in the range of 50 percent or more!

In this respect, in terms of timing it seems as if Europe is ahead of the United States. Furthermore, in Europe, the banks account for the "vast majority of all debt financing while in the United States the banks hold less than 30 percent of all loans." So, the problem is a smaller one for the banking system in the United States, but many of the "troubled" United States banks have not yet gotten their capital ratios into a position where the distressed assets with larger charge offs might be sold off. Thus, this is another area of asset write downs that the "smaller" American banks will have to go through before the banking system is more fully "normalized."

Here we are seeing why it takes a banking system so long to return to a solvent position following a period of very severe financial distress. The commercial banks work a long time to achieve a position of financial insolvency. The environment of credit inflation gets the whole process going, provides the "music" to keep everyone dancing, and this environment results in the "dancers" going on and on…as Chuck Prince, former Chairman of Citigroup so poetically stated…until the music stops.

If the asset problems were all recognized within a very short space of time, once the music stopped, the system could not survive. It is the objective of the central bank and other regulators of the financial system to keep the banking system afloat then these authorities must do everything possible to keep the doors of the banks open and allow for a slow, uneventful resolution of the bad assets in the banking system. This is exactly what the Federal Reserve and the FDIC has done over the past six years. And, we are still seeing the banking system in the United States shrink by 200 banks a year.

We are now seeing with more clarity the extent of some of the problem assets that still exist on the books of the banks. We will see even more evidence of the presence of these problem assets in the future.

Source: Problem Assets: A Reason Why Some Smaller Banks Still Aren't Lending