Could there be a glimmer of life in bank loans at Small, Domestically Chartered Commercial Banks?

The latest figures released by the Federal Reserve on the Assets and Liabilities of Commercial Banks in the United States gives some indication that this is happening. In the latest four weeks for which we have data, all Loans and Leases at commercial banks declined by $22 billion, but loans and leases at the smaller banks actually rose by $50 billion. And, this rise was across the board.

The central premise of “This Time is Different: Eight Centuries of Financial Folly," (Princeton University Press, 2009) is that people need better time series data for studying the history of financial crises. The authors, Carmen Reinhart and Kenneth Rogoff, believe that researchers, as well as practitioners, who have studied instances of financial crises, have neither a long enough nor a broad enough historical perspective to really understand the commonalities that exist in all cases of financial disruption.

In an attempt to correct this deficiency, Reinhart and Rogoff build a database of relevant information which they believe will contribute to the better understanding of what a country, or the world, experiences before, during, and after a financial crises. They have collected data from sixty-six different countries and their sources go back eight centuries.

The Federal Reserve, the Bank of England, and the European Central Bank are all keeping interest rates exceedingly low and are continuing to engage in “quantitative easing.” The central banks have claimed that they are caught in a “liquidity trap” and cannot force interest rates to go any lower, especially below zero. Their solution is to continue to force liquidity into the banking system in order to keep the financial system functioning and to encourage commercial banks to start lending again.

I have a problem with this interpretation and have been writing about it since the events of the fall of 2008. The liquidity problem the central banks have focused upon is one connected with the liquidity of bank assets and security holdings that are hard to price. The central banks, as well as the United States Treasury, has seen this problem as a liquidity problem.

In part one of this article, I discussed what I saw as the reasoning behind the strategy the Federal Reserve is building to reduce the massive amount of excess reserves that it has injected into the banking system. The basic strategy seemed to be logical and reasonable and consistent with the way that economists usually think. That is, the arguments of economists always contain the assumption: “all other things held constant.” In other words, this is the plan, given that nothing else changes.

But what is missing from the proposed strategy that the Federal Reserve is developing that might be crucial to the success of this strategy?

Interest continues to grow about how the Federal Reserve is going to remove all of the reserves that it has injected into the banking system. The articles are getting personal now.

See, for example, the article in the Wall Street Journal Tuesday morning that actually brings us a name, Brian Sack, who is the head of the markets group at the Federal Reserve Bank of New York and the person responsible for developing the “exit strategy” that the Fed will use to remove the $1.0 trillion, more or less, excess reserves that reside on the balance sheets of the country’s commercial banks.
The basic problem facing the Federal Reserve is that the Fed has pushed an enormous amount of funds into the banking system and, at some time, is going to have to remove those reserves so as to avoid the possibility of stimulating a massive amount of inflation in the United States. Thus, the Fed needs to go back to where it was once, or, at least, somewhere around there.

New financial regulation is on the horizon. As with the health care program, the Obama administration is providing very little unified leadership as to where it really stands and, as a consequence, there are a multitude of plans being tossed out into the air. There is, more or less, a Treasury plan, an FDIC plan, a Barney Frank plan, a Federal Reserve plan and so on and so on.

Where we will end up is anyone’s guess right now. At present, no real leader has emerged. Just like the health care debate.

Bloomberg put up a headline Thursday morning that I found eye-catching: “Stock Market ‘Bubble’ to End, Morgan Stanley Says."

Ruchir Sharma, who oversees $25 billion in emerging-market stocks at Morgan Stanley, is quoted as saying, “the (global stock market) rally will end as the effects of the (government) stimulus begins to fade and the credit bubble caused by easy money disappears.”

When the history of the recent financial crisis and Great Recession is written, the basic conclusion that will be presented is that a financial crisis can be ended and a major recession turned around if the government throws massive amounts of money at the economy.

And, even after all this money is thrown at the economy, the calls for more and more stimulus remain. For example, the lead editorial in the New York Times Monday morning called for additional stimulus. The Times struggled to come up with legitimate proposals for additional spending and ended up with only two: extending unemployment benefits and a program to “ease the dire financial condition of the states.” The newspaper bailed out with the claim that, “To be highly effective as stimulus, cash aid must be targeted to needy populations.” But, the Times can’t do any better than that.

Several of the aggregate economic indicators are indicating that the economy has bottomed out. Industrial Production seems to have hit a bottom in June 2009 as the year-over-year rate of decline on a seasonally adjusted basis was -13.3%. Since then the negative rates of growth have fallen: in August the rate of decline was -10.4% and in September this rate dropped to -6.1%. The index has actually increased, month-over-month, beginning in July.

The decline in real Gross Domestic Product (GDP) lessened in the third quarter this year on a seasonally adjusted year-over-year basis. The greatest year-over-year decline came in the second quarter of 2009 when real GDP fell at a 3.8% annual rate over the second quarter of 2008. The first look at the third quarter number is to be released on Thursday. According to the Wall Street Journal, estimates for the third quarter over the second quarter annual rate of increase stand at a positive 3.1%. If this quarter-over-quarter rise takes place, the year-over-year rate of decline for the third quarter of 2009 will be -2.4%.

Mervyn King, Governor of the Bank of England, gave a speech the other night and set off somewhat of a storm…at least across the pond. And it is a discussion that needs to be heard here in America.

Not only did it get a lot of play in the press, but it elicited an immediate response from Prime Minister Gordon Brown and Alistair Darling, his Chancellor of the Exchequer. Here is an example that appeared in the Financial Times, “King Calls for Break-up of Banks."

“This has been the year of coping with the economic mess. Next year will be the year of coping with the deficit mess that follows the economic mess.” -- Wall Street Journal writer Gerald Seib.

“The timing is tricky” because next year is an election year, but Obama is going to do it. Yes we can!

Questions are now being asked about the nature of the rise in the stock market. These questions have to do with the reality of the rise, how high the market will go and when the economy will produce results that are consistent with the optimism captured in the stock market rise.

There is another way to look at the rise in the stock market since March 2009: the rise could be just another asset bubble.

This is the third post in a series (Part One is here and Part Two is here) designed to review the progress of the Federal Reserve in its efforts to exit the position it has created for itself by more than doubling the size of its balance sheet.

Some fear that if the Fed cannot reduce the size of its balance sheet that the amount of reserves that have been put into the banking system will explode in the creation of new credit, which will be followed by an explosion in the various measures of the money stock. This can only be inflationary with substantial concern that such inflation could turn into hyperinflation.

Another commentary on the state of the dollar, well worth reading, was written by Martin Wolf and presented in the Financial Times Wednesday.

Wolf begins by stating that, “it is the season of dollar panic.” He then specifically lists two parties, gold bugs and fiscal hawks, that believe that the dollar “is on its death bed. Hyperinflationary collapse is in store.”

This is my monthly report on bank lending. Last month I reported on the continued absence of the commercial banking industry in loan markets. (See my post of September 10, 2009, “Bank Lending Stays on the Sidelines”.) Bank lending was still absent during the most recent month, but there now seems to be a significant shift in the commercial banking industry: greater changes seem to be taking place in the smaller banks than we have seen during the current economic crisis.

This deterioration in the industry figures coincides with the increasing number of failures that are registering with the Federal Deposit Insurance Corp. (FDIC). This problem made the front page of the New York Times on Sunday. And, with more than 400 banks, almost all of them small ones, on the FDIC's list of problem banks, we can expect the number of failures to grow and the bank lending figures to continue to shrink.