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The Open Market Committee of the Federal Reserve System meets today, but no one is expecting that there will be any change to the Fed’s target Federal Funds rate. The reason given is that the economy still remains exceedingly weak with the unemployment rate remaining just below 10% and the inflation rate as measured by the consumer price index less food and energy, the Fed’s preferred price measure, hovering between a 1% and 1-1/2%, year-over-year rate of increase. This latter fact, combined with the information that there is a lot of unused capacity in United States manufacturing, is believed to be the primary argument for keeping the target interest rate at such a low level.

I, too, believe that the Open Market Committee will not change the target rate of interest at this time, but I still believe that the Federal Reserve is very troubled about the condition of small- and medium-sized banks. To repeat the statistics again, the FDIC has more than 700 banks on its problem list with the expectation that over the next 12 to 18 months there will be three to four banks closed, on average, every week. The small- to medium-sized banks in this country do not appear to be in very good shape.

To raise rates at this time and remove reserves from the banking system could make the situation amongst the small- to medium-sized banks much more difficult. Yes, according to Federal Reserve statistics, small domestically chartered commercial banks in the United States make up only about 34% of the banking assets of domestically chartered banks in the United States as of the first week of March 2010. (The largest 25 domestically chartered banks therefore make up about two-thirds of the assets of domestically chartered banks in the country.) Therefore, about 8,000 banks in the United States hold only one-third of the bank assets in the country. Perhaps this is not sufficient to worry too much about.

However, one could argue that another reason, perhaps the main reason, that the Fed does not want to raise its interest target is the shaky shape of this portion of the banking system.

The smaller banks in the country hold about $320 billion or about 9% of their assets in cash assets in the first week of March. This is up from 6% one year ago!

Furthermore, these banks hold about 12% of their assets in Treasury and Agency securities with another 7% of assets held in other securities. (This total of 19% is up from around 17% one year ago.)

Thus, these banks hold almost 28% of their assets in cash or marketable securities. This is up from about 23% at the same time in 2009.

One keeps looking for “green shoots” amongst these smaller banks. The bigger banks are going to make it now and do not present much of a worry to the Feds. In fact, the bigger banks are raking in the profits, one way or another.

The problem is that I don’t see much happening in the smaller banks. The total assets of the bank are about the same as one year ago but, as the above figures show, these banks have gone 100% risk-averse. It seems as if they are just holding on, hoping to survive the worst.

Total loans and leases at these banks are down a little more than 6% year-over-year. However, these totals are down almost $88 billion over the past 13 weeks, a drop of almost 4% in about three months.

Commercial and Industrial loans are down around 9%, year-over-year, although they have only dropped about $6 in the 13-week period ending March 3. Business loans are down severely and show no sign of picking up. This has got to have an impact on Main Street because the businesses that deal with these banks have few alternative sources of funds.

Another major area of concern to the small- to medium-sized banks is their portfolio of commercial real estate loans. These loans are down by more than 5% year-over-year and down almost $40 billion over the last 13-week period.

This is an area of major concern to these smaller banks and are expected to be the source of extended troubles to the banks over the next 18- to 24-months. This is the area over which Elizabeth Warren, the head of oversight for Congress of the TARP funds, has expressed extreme anxiety.

The fear that one has in this area is that the loan problems of these small- and medium-sized banks have not really been fully worked out. As such, these banks are behaving in a very conservative fashion for a reason. They are building up cash assets and liquid assets in order to provide protection for themselves to weather potential loan charge offs over the next year or so. If interest rates begin to rise and the Fed begins to withdraw reserves from the banking system, these banking organizations could be forced to charge off many of these loans and this could cause severe damage to their capital positions. It is my belief that the Federal Reserve is cognizant of this situation.

Overall, the Federal Reserve is keeping excess reserves in the banking system at record levels. In the two weeks ending March 10, 2010, excess reserves in the banking system average roughly $1.2 trillion.

The banking system as a whole is recording about $1.3 trillion in cash assets in the banking week ending March 3. This is divided up between Large Domestically Chartered banks with about $570 billion, Small Domestically Chartered banks with about $320 billion, and Foreign-Related institutions with about $460 billion. (What is perhaps interesting is this latter figure which was about $230 billion one year ago. Just what is going on with these foreign-related institutions?)

The loan portfolios of the large banks continue to contract as well. Total loans and leases are down about 7% year-over-year, and have dropped $85 billion over the last 13-week period. The two biggest declines registered come in Commercial and Industrial Loans, $31 billion, and Residential loans, also around $31 billion. There does not seem to be much activity in the Commercial Real Estate portfolio, contrary to what seems to be happening in the small- to medium-sized banks.

The conclusion?

No “green shoots” but lots of problems remaining in the smaller banks!

Surveys coming out from the Federal Reserve indicate that fewer banks are tightening up their lending standards. This is promoted as a good sign. Other indicators in housing construction, foreclosures and bankruptcies are seen as pointing to a turnaround in the banking system.

I don’t see it yet. And, I don’t think that the Federal Reserve really sees it yet.

The banking system must begin lending again if we are to have an economic recovery and job growth. Many companies seem to be tapping the capital markets as debt issues climb. However, these are not Main Street businesses. And, history teaches us, the banking system must be there to underwrite any expansion of business activity because, for many, Main Street is the only place they can raise funds.

Source: Small Banks and the Federal Reserve