Is a Crunch Coming for Smaller Banks?

by: John M. Mason

Two months ago I was hoping I was seeing some “Green Shoot in Smaller Bank Lending." Last month I found very little encouragement in the banking data released by the Federal Reserve: “Still No Life in Banking."

The most recent data seem to indicate that things may be getting worse.

Remember, as of June 30, 2010, the FDIC listed 829 banks on its list of problem banks, and these banks are the smaller ones. Note that this is more than ten percent of the commercial banks in the banking system. Elizabeth Warren, in congressional testimony, has stated that there are at least 3,000 commercial banks facing major problems in the future, primarily in the area of commercial loans (details here). I have made my own forecast that the number of domestically chartered banks in the United State will drop from around 8,000 to less than 4,000 in the next five years or so.

Total assets in the smaller banks in the United States (the smaller domestically chartered commercial banks consists of all banks below the top 25 in asset size and make up about one-third of the banking assets in the United States) are about the same this year as they were last year. Yet, cash assets in these banks increased by almost 38% from August 2009 to August 2010 and by more than 2% in the four week period ending September 29, 2010.

The concern, of course, is that the smaller banks are preparing for more trouble in the future. The larger banks are now in the process of reducing their cash assets: the cash asset at large, domestically chartered banks are down about 4% over the last four weeks; down about 5% over the past thirteen weeks; and down about 6% over the past year.

Thus, the decline in excess reserves that has occurred in the banking system over the last six- to eight-week period, has come in the big banks indicating that they are prepared to adjust to a new lower level of liquidity in the banking system.

However, the smaller banks are not ready to become less liquid, just the opposite. This, to me, indicates that the Federal Reserve is staying “extremely loose” not so much because the economy is weak, but because the solvency of the smaller banks in the banking system is in question.

There is no doubt that the smaller commercial banks in the United States are getting more conservative. Loans and leases at these smaller institutions continue to decline; they have dropped about one percent in the last four weeks.

The thing to keep an eye on, however, is the commercial real estate portfolio. In the smaller domestically chartered banks, the decline in these loans on the bank balance sheets seem to have accelerated in the past four weeks and in the past thirteen weeks from earlier time periods.

Commercial real estate loans have declined across the board, but the concern is that commercial real estate loans make up about 26% of the assets of the smaller domestically chartered banks and only are about 8% of the assets of the large banks. The declines in the smaller banks have a proportionately larger impact than does a similar decline in the big banks. Furthermore, this is where Elizabeth Warren pointed us to in her congressional testimony.

The two categories of loans that have recently increased at the smaller banks are “Revolving home equity loans” and “Credit card and other revolving plans.” The home equity loans at these smaller banks have risen by about 2% over the past 13-week period and are up slightly over the past 4-week period. At the big banks these loans are down by over one percent for the longer period and down slightly less than one percent for the shorter period.

Credit card and other revolving debt at the smaller institutions is up by over 4% in the past 13-week period and up by about 3% in the past 4-week period. At the larger banks, these numbers are down 3.5% for the longer period and down one percent for the shorter period.

Recent analysis of credit card debt indicates that, for the larger issuers, much of the decline in credit card debt has come because of these organizations charging off bad debt.

Could it be that the smaller banks are not charging off their delinquent home equity loans and credit card or revolving consumer debt because they don’t have the capital to absorb the losses? Could this be the reason that these loans are increasing at the smaller banks and not at the larger banks?

If one accepts this analysis, then the smaller banks have a lot to do on their balance sheets in the future to handle not only troubled commercial real estate loans but to handle revolving credit debt. Do the smaller commercial banks have the capital to go through this process?

There remain many concerns about the commercial banking system. Now that people expect that we will go through a period in which the profit performance of the larger banks is to be relatively flat, might this put even more pressure on the overall United States financial system?

My guess is that the big banks will do just fine. The problem is with the smaller banks, and the situation does not look encouraging for them. I still believe that this is the main reason why the Federal Reserve is keeping excess reserves in the banking system at such a high level. The Federal Reserve, in my mind, is scarred silly that there still may be massive bank failures in the future. The FDIC has been smoothly working through bank closures and helping many distressed institutions to find partners to absorb them. The question remains as to whether the massive amounts of liquidity in the banking system will allow this “work out” to continue its smooth and quiet pace in the face of growing problems with commercial real estate debt and consumer revolving debt?

Disclosure: None