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While the economy needs the banking sector to get healthy before it begins to grow, we are still waiting for the banks to show some signs of life.

In the past few months, loans and leases in the commercial banking system continued to decline.

Credit extension over the past six months was down about 2 percent and for the last three months it was down by 1 percent. Loans and leases on the books of commercial banks also declined by $18 billion over the past month.

The category of loans taking the biggest hit has been commercial real estate loans. For over a year now, concern has been expressed about the weaknesses that were expected in this sector and, to date; this forecast has been proven to be correct. The expectation is that the commercial real estate sector will continue to remain week in 2011.

Commercial real estate loans have declined by more than 9 percent over the past year, the largest declines coming in the largest banks in the country. These loans have declined by more than 11 percent at the biggest 25 banks in the country, while they have declined by almost 8 percent at the smaller institutions.

This trend also existed over the past six months, three months, and one month with declines for the whole industry of about 5 percent, 3 percent and 1 percent, respectively. Note these are not annualized rates.

It has been the case that the rate of decline in these loans has been greater in the largest banks.

Every classification of loan continued to decline over the last six months, with all real estate loans taking the lead.

Cash assets at all commercial banks registered declines over the past year as the Federal Reserve has been less generous in pumping out funds…until recently, of course.

Over the year, cash assets at commercial banks fell by 12 percent. However, there is another story embedded in these figures! Cash assets at the largest 25 commercial banks fell by almost 30 percent over the past year, declining by 22 percent over the last six months and by 10 percent over the last quarter. Thus, one could say that the bigger banks were becoming less conservative in that they were relying less and less on balance sheet liquidity to see them through the upcoming months.

The story is entirely different for the smaller banks. Over the past twelve months, cash assets at domestically chartered commercial banks that were smaller than the largest 25 banks ROSE by more than 15 percent. Over the past six months, these smaller banks increased their holdings of cash assets by more than 5 percent. Only in the last month have cash balances declined at these banks, but the decrease was modest, at best.

My concern over the past twelve to eighteen months has been the health and solvency of the smaller banks in the banking system. Not only are loans at these institutions down significantly over this time period, their cash holdings have increased dramatically. The implication of this movement is that the smaller banks are being very, very conservative in their management in order to weather as well as possible the removal or write-down of bad assets from their balance sheets.

Over the past twelve months, the Federal Deposit Insurance Corporation (FDIC) has been closing approximately 3.5 banks per week. As of the end of September 2010, the FDIC had 860 banks on its problem bank list, up from 829 at the end of the second quarter. (Remember also that the FDIC closed about 45 banks during the third quarter.) The number of banks on the Problem Bank List now represents 11% of all FDIC insured institutions, a little over 7,800 banks in total. Furthermore, in judging this picture we need to recall that earlier this year Elizabeth Warren, in Congressional testimony, stated that there were about 3,000 banks facing severe problems in their commercial real estate loan portfolio.

One can interpret these data as indicating that the commercial banking system, especially the banks not included in the largest 25 banks in the country, is still facing serious difficulties. Not only are we getting this picture from the banking regulators themselves, we are seeing these banks acting very, very conservatively in the face of the massive injection of funds into the banking system.

It is this picture that leads me to believe that one of the major reasons the Federal Reserve has constructed QE2 is that the banking system continues to need support as the FDIC closes as many banks as it has to as smoothly as possible.

Furthermore, what could do more damage to asset values in the portfolios of commercial banks than to have interest rates rise?

The Fed says it is trying to keep interest rates from rising in order to help encourage economic growth, but maybe there is one step missing in this explanation.

The Federal Reserve needs the commercial banking system to start lending again so that businesses can begin investing again and the economic recovery can get on track.

However, the Federal Reserve needs to keep interest rates from rising so that financial assets in the commercial banking system don’t decline further and force even more banks to close their doors.

A substantial rise in interest rates would be disastrous for the banking system.

Also, if interest rates rise even modestly, it is highly likely that commercial banks, given the condition they are in, will act even more conservatively and be even more reluctant to pick up their lending to businesses and consumers.

The Federal Reserve needs a vibrant and active commercial banking sector in order to generate sustainable economic growth.

The Federal Reserve is not there yet.

Source: Little or No Life in the Banking Sector