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Downgrading large, internationally significant financial institutions did little to change market attitudes about the financial condition of these institutions. The general market response was “too little, too late.”

As is too well known, rating agencies tend to be followers not leaders. The question always is: well, how far behind are the rating agencies this time?

In this respect, the rating agencies are in the same boat as the regulators -- they are always behind the curve.

As far as the banking system itself ... the banking system is not doing all that well, but we knew that. But the U. S. banking system is doing better than the banking system in the eurozone, if that is any consolation.

The U.S. banking system is still holding almost $1.5 trillion in excess reserves. To me, this means that the banking system, in general, is still is such bad shape that it does not want to make many loans and is perfectly content to be sitting on all the excess reserves that the Federal Reserve has supplied it.

This situation is not unlike the one that existed during the Great Depression. In general, commercial banks are not in good shape. This general condition also existed at the time of the Great Depression. Too much debt had been created and individuals and businesses could not pay off the debt that they owed. Many banks were technically insolvent. Commercial banks continued to be closed and many of the banks that still had their doors open were just waiting for the regulators to visit them and pull down the shades on their windows.

As we have seen this year, the FDIC continues to close smaller banks, more than one per week, while many other weak banks are acquired and so go out of independent existence.

While lending in the banking system has increased in aggregate over the past year, there still are disturbing signs. For one, cash assets at the smaller, domestically chartered banks increased over the past year by about $33 billion while cash assets in the whole banking system declined. That is, it looks like the demand for excess reserves in the small banks has actually increased, a sign of management concern.

Secondly, the commercial real estate sector continues to cause the domestically chartered banks problems. These loans continue to decline at the largest 25 domestically chartered banks in the United States as well as in the rest of the domestically chartered banks over the past year.

Whereas there is some signs that the residential real estate market may be leveling off, problems continue to exist within the commercial real estate area. It is here that we find why many of the smaller banks are under such stress.

During the “glory days” of the recent expansion, many of these smaller banks strained to put commercial real estate loans on their books to generate bank expansion. In order to support this expansion the smaller banks became “liability managers,” something small banks hardly ever did in the past. So these managements made two mistakes: they got into commercial real estate loans, which they did not have the expertise to do; and they got into the purchase of funds, again something they had never done before.

Now these smaller banks are paying the price for their lack of discipline. But it was the thing to do in another time period. The smaller banks will continue to face balance sheet problems for some time and the number of commercial banks in the banking system will continue to decline.

Another thing to watch is what is happening between banks. Nearly 40 percent of the increase in bank loans over the past year came in a category titled “Other Loans and Leases” and this category includes Federal Funds and reverse repos with nonbanks and “All Other Loans and Leases.” This latter group is defined by the Federal Reserve as Including “loans for purchasing or carrying securities, loans to finance agricultural production, loans to foreign governments and foreign banks, obligations of states and political subdivisions, loans to nonbank depository institutions, loans to nonbank financial institutions, unplanned overdrafts, loans not elsewhere classified, and lease financing receivables.”

Foreign-related commercial banks increased loans in the first category by over $66 billion. Large domestically chartered banks increased loans in the second category by more than $34 billion. In order to explain this I would like to concentrate on the subset “loans to foreign governments and foreign banks.” Indications are that these large banks committed a lot of money to “foreign governments and foreign banks” over the past year. This is where some of it shows up.

And what was the biggest item to increase on bank balance sheets in the United States? Net deposits due to foreign-related offices of foreign-related financial institutions in the United States. The total increase over the past year was almost $290 billion!

It looks to me like a lot of the lending activity that took place in the United States and particularly in the largest 25 domestically chartered banks were to “offshore” entities. In other words, a substantial portion of the funds the Federal Reserve injected into the United States banking system has migrated into foreign hands.

Thus, the Federal Reserve System is not only supporting a weak United States banking system -- it is also going to help support a weak world banking system.

One final point of the current situation in banking: Fundamental Keynesian economists have argued that the current dilemma facing the monetary authorities today is a “liquidity trap” much as the one they claim the central bank faced during the Great Depression.

In my mind, these Keynesian fundamentalists are as wrong about the current situation as they are about their interpretation of the Great Depression.

Interest rates are low and yet the economy is not expanding because the banking system is still so weak that the banks are not lending, not because the economy is in a “liquidity trap.” The problem is a supply of loans problem, not a demand for money problem.

And, this applies to Europe as well as to the United States. A stronger recovery in the United States will not occur until the U. S. banking system becomes solvent once again, debt balances in the economy are reduced, and governments realize that they are not the solution to every problem.

Source: The U.S. Banking System: Weak, Yet Still Supplying Europe