Why Small Banks Are The Key To Recovery-Part 1

The critical factor in our economy right now is a declining money supply which has been the result of the “credit crunch” or what Keynesians call a “liquidity trap.” We have discussed this frequently on this blog. I believe deleveraging is the key to an economic recovery and measures of business. The result of deleveraging is deflation, but instead of seeing deflation as a negative, it is a necessary step for growth.

I look at these issues quite differently from Keynesian and Neo-classical economists. As we have seen the Fed has been unable to stimulate money growth through zero interest rate policy (ZIRP) or through quantitative easing (QE). This is something that their theories not been able to adequately explain, and the outcomes of their policies have led to continued high unemployment, declining growth, declining money supply, and deflation. The policy makers at the Fed and Treasury have run into the same problems that mired Japan’s economy for almost 20 years: sluggish growth amidst deflation.

The reason we are seeing money supply decline is twofold. Banks have (1) tightened lending standards which makes credit less easy to obtain, and (2) banks are finding it difficult to find credit worthy borrowers. While the Money Base has increased dramatically, these funds sit in the Fed as “excess reserves” where banks earn interest on it from the Fed. I will explore this issue in a moment.

But first …

There are two sides to this credit issue: consumers and businesses. Consumers are cutting back spending, paying down debt, increasing savings, and are cutting back borrowing (even if they could get a loan).

Here is the story of consumer credit:

While the consumer is important to the economy, it is not the consumer that I wish to focus on in this article. Consumers are doing all the right things now to help the economy recover. Their deleveraging and savings will help fuel new growth.

What is more important at this stage of our economy’s lack of recovery are business loans. In this article I wish to specifically focus on smaller businesses, which comprise one-half of the economy and one-half of the jobs in America, and their banks.

There are two banking systems in the U.S. now: a few very large money center banks which have recovered or are more or less on their way to recovery, thanks to TARP, and all the other banks. Many of the regional and local banks are still suffering, mainly as a result of commercial real estate (CRE) loans they made during the boom. As you recall, they sold off their residential loans, but kept the CRE loans.

The Fed would like all banks to start lending. Increased lending activity would indicate a growing economy. Through the fractional reserve banking system, banks can lend about 10:1 which multiplies the effect of the Fed’s money policy. You can see this effect in the M1 Multiplier charts. This is the Fed’s main inflation generator. If banks aren’t making loans and are holding all the cash that the Fed has tried to pump into the economy as reserves, then not only does the money supply not grow, it can shrink, which is what is happening now. This is deflation.

Courtesy Michael Pollaro TrueSlant

The process by which banks would start lending and create real, organic economic growth requires two things to happen:

  1. Banks need to get rid of bad debt on their books, which is mainly CRE debt, and raise capital and return to sound banking practices.
  2. Businesses need to see “regime certainty” and steady economic recovery before they borrow and expand their businesses.

As to No. 1, the government has been doing everything they can to prevent banks from liquidating bad investments. And as to No.2, the government’s barrage of new legislation is creating uncertainty for businesses (“regime uncertainty”). That, plus the stimulus seesaw and new banking policies (No. 1) are inhibiting economic growth which makes businesses reluctant to borrow. It is obviously much more complex than this, but these are the brightline issues.

There are several things to watch in trying to assess whether or not banks are lending. The first is business loans:

As we can see, the level of business loan activity seems to be picking up, but it is still very depressed. Most lending is coming from the big banks and they are lending mostly to medium and large size firms.  A new Fed survey reported that 7 out of 57 banks surveyed reported easing credit for these companies. This is the second quarter of easing credit conditions. But 6 of 28 big banks (14.5%) said they had eased credit standards for small companies; this is the first such easing since 2006.

But there is a reason they are easing credit for small borrowers that doesn’t have anything to do with lending standards. Rather, it is because the big banks now realize that the Dodd-Frank Act took away some of their big profit centers and they understand that they will now be more like banking utilities providing garden variety services to borrowers and savers. Consequently the big banks are now aggressively going after as much business as they can get and this includes small business borrowers. As a result of this competition, credit has eased.

But, credit demand has not significantly increased. Credit is still significantly tighter than it was before the crash and banks are reporting that business customers are still reluctant to borrow. The Fed report confirmed that loan demand is still weak after falling during the first quarter.

The latest survey by the National Federation of Independent Business, a separate trade group, last month found 91% of small-business owners reporting that their credit needs were met or they did not want to borrow, while only 4% cited financing as their top business problem. Uncertainty about the economy held back far more firms from investing: The percentage of business owners planning to make capital expenditures in the next few months fell one point to 18%, two percentage points above the 35-year record low. Only 5% said right now is a good time to expand facilities.

This lack of borrowing has hit the earnings of large banks such as BofA, JP Morgan, and Citi.

“The results from the larger banks are confirming our view that the U.S. economy is continuing to deflate,” said Christopher Whalen, managing director at Lord, Whalen LLC’s Institutional Risk Analytics.

According to the Fed report, small banks are still reluctant to lend. This is where CRE debt comes into play.

Almost all of the failed banks taken over by the FDIC have failed because of CRE debt. Of the five banks closed on July 31, according to Treppwire:

For the group, commercial real estate accounted for 71% of nonperforming loans. Construction and land loans were 42% of the total, while commercial mortgages comprised 29% of the total. Real estate (including residential) constituted 90% of the problem loans among these banks.

CRE debt is clogging the balance sheets of these small and regional banks. These banks are worried about their capital base if the CRE market doesn’t improve, which presently is unlikely. If too many of these loans go into default, the banks will have to reserve more of their capital which means they will have less capital to lend. U.S. banks’ allowances for loan losses stood at $221 billion as of March 31, 2010, which is equal to 4.1 percent of total loans. Banks are more concerned about their survival than they are about lending. That is why “excess reserves” are so high.

On the other hand, there appears to be some improvement in small banks.

First, earnings are uneven, but, according to American Bankermaybe improving:

These small banks continued to get hit with nonperforming loans and chargeoffs, but they did not take as bad of a beating as they did the previous quarter [Q1] and a year earlier. Median net income rose by 4%-9.6% from the previous quarter depending on the region, according to a report from Sandler O’Neill & Partners LP and SNL Financial LC. At the same time, regional declines in nonperforming loans ranged from 2.3% to 9.5%. Lower expenses, higher net interest income, and the strides in credit quality fueled earnings growth.

I believe the more typical scenario is shown in earnings reports from banks like Zion Bancorp and M&I: they were hit with wider loan losses and declining loans.

Zions reported a loss of $135 million after the market closed Monday. The Salt Lake City-based lender’s $1.96 billion in nonperforming loans—loans at high risk of becoming uncollectable—fell modestly over the first quarter, but still remain higher than three quarters ago. The bank’s core revenue also shrunk as total loans fell for the fourth straight quarter.

M&I, based in Milwaukee, reported a net loss of $174 million and said its troubled loans continued to improved, a key issue for a bank that made big bets on construction loans and has now reported a loss in eight of the nine last quarters. … Commercial loans and leases were $12.2 million in the quarter, down 17 percent, and lending to customers for construction plunged 35 percent. Total loans fell 14 percent.

I tend to believe in the more pessimistic outlook for regional and local banks.

Tomorrow: The problem with ‘extend and pretend” and a glimmer of hope.


12 comments to Why Small Banks Are The Key To Recovery-Part 1

  • Buck


    You have read enough on the inflation/deflation debate to know that definition of terms at the outset is crucial. You say that deflationists conflate concepts of deleveraging and deflation, which arent the same thing. Can you please elaborate?

    Is contraction of credit a decrease in money supply?
    Is deleveraging a process of contracting credit, or something else?


    • If I pay down my debts, that is deleveraging. If the Fed contracts the money supply and the money supply actually shrinks, that is deflation. If the Fed has been ineffective in inflating because of ZIRP, then the cause of deflation is that banks aren’t lending and money supply contracts (as in today). Banks aren’t lending because they are loaded down with CRE debt. Businesses aren’t borrowing because they are uncertain. The money supply shrinks, despite the fact that banks or businesses aren’t deleveraging. Deleveraging can and does lead to deflation, but you can have deflation without deleveraging. Credit can contract in inflationary times as well (1970s). See my latest article on banks. As you may have guessed, our fiat money system is based mostly on the creation of debt, and if everyone and the Fed paid off their debts, money as created by the Fed would disappear. You can also see my series on Inflation, Deflation, and Hyperinflation.

  • Colin

    Define Deflation and Inflation
    Webster’s says, “Inflation is an increase in the volume of money and credit relative to available goods,” and “Deflation is a contraction in the volume of money and credit relative to available goods.” To understand inflation and deflation, we must understand money and credit.

    • I like this question. Webster is not where you should be looking for a definition. Austrians define inflation as an increase in the supply of money. Doesn’t have anything to do with goods. Technically it is the increase in supply without an increase in demand for money. This causes many problems, mainly one of entrepreneurial calculation due to artificially low interest rates, but one of the effects of an increase in money supply is rising prices. Basically the folks who get the new money first are getting something for nothing. You can’t create wealth by printing money. So they bid up the price of goods they want with the new pieces of green paper, causing prices to rise. The poor guy at the end of the cycle doesn’t get the new money, only the rise in prices. When you really pump up money supply, demand for money falls because people want to get rid of it as soon as possible because of rapidly rising prices.

  • Buck

    Deleveraging is destruction of credit-money (as noted in your addendum). That is why I don’t understand why you don’t equate deleveraging with deflation. If I am reading you correctly, I suppose in the aggregate, sufficient creation of fiat (government) money could offset total credit deflation. However, in our current age this would be truly something to witness. Private debt relative to base money is like a mountain shadowing a mole hill.

    Note: if businesses are not borrowing, they are de facto deleveraging, unless they’ve stopped payment on existing loans.

    • I think I said that it is. It’s not quite “destruction” just that the credit entry on bank’s books in the amount of the loan is reduced by the amount of the loan paid back. The loan that created the money was an entry on the liability side, the note being on the asset side of the bank’s books. You make a good point on the molehill thing, but QE can do a lot of damage. If businesses aren’t borrowing they are just not increasing money supply, not deleveraging. If they pay off loans that reduces money supply. If everyone paid back their loans, that would be deflation.

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  • Buck


    To clarify: businesses, as a sector, already have an existing net loan balance on their books. If the sector ‘stops’ taking on fresh loans, the supply (from that sector anyway) is instantly in contraction due to existing repayment schedules, however benign. To hold the level of (buiz sector) money supply at a constant requires at minimum enough new loan generation to offset principle repayment flows. The minute I max my card and am reduced to repayment, even at the montly minimum, I am deleveraging.

    QE cannot do the damage if there is no private sector demand to borrow and spend the funds. Bernanke could expand bank reserves 600% a la Japan and have the same result, zero inflation. Businesses and consumers alike will eschew adding debt even at 0% if they are more conerned with repairing balance sheets.

    Because of this, my prediction is that we are likely to find any remedy on the monetary side innefective. It is fiscal policy that has the leverage to affect change.

    And to prevent a sudden rise in blood pressure, my preference would overwhelmingly prefer it implemented on the tax (reduction) side versus more outlays.


    • Buck:

      I think QE works differently than ZIRP. The money goes into the accounts of, say Goldman or Morgan, who spend it on other financial assets. The idea is that this bypasses the banks who hold it as reserves for the reasons I have mentioned. QE impacts, I believe, the other half of the economy who do benefit from QE–Big Business and Big Money. Thus, when Caterpillar or Coke step up to the commercial paper window, there is plenty of money there. Or if they wish to float bonds, ditto. Or GS buys stocks or other financial assets. I guess I can’t “prove” that QE will work, but my theory is that if they pump in enough, it has to have some inflationary impact on money supply and this will eventually spill over into the the other half of the economy. So don’t ask me what “enough” is, but it’s more than $2 trillion. My guesstimate was $3 to $5 trillion. And that’s a lot of fiat money sloshing around.

      And, what is the “fiscal policy that has the leverage to affect change”?

  • Buck

    I’m not sure what you mean by ‘pump in’. QE is merely the Fed ‘swapping’ assets with financial institutions (reserves for securities). It does not ‘add’ net assets to the private sector; it only changes the composition to a more liquid type (a non-issue I would argue, but maybe you disagree). Therefore the process does little, if anything, to address the issue: economic contraction due to unprecedented debt and leverage. The only way QE could ‘ease’ this is if Fed was purchasing/removing the completely toxic non-performing assets from banks (as noted in your point 1 (of 2) in above article), but this is not what we’re seeing, at the moment.

    On the other hand, fiscal policy (taxing/spending) is much more direct. Reduced taxes would chip away at the balance sheet problem immediately and in a much more democratic manner. Increased take-home equals instantaneus balance-sheet repair economy wide, from the bottom to the top, not the traditional top down arrangement.

    The bottom line, is only that the fiscal policy has much more direct ‘means’ of affecting things than the monetary. Obsessing over Fed actions (in times like these) is putting the cart before the horse. The Fed can’t write stimulus checks; the Government can. Because of this, and since the Fed as you note is accomodating (i.e. faux independence), it is the fiscal policy that needs to lead. We can debate day and night about what shape it should take, but the debate and focus should be centered squarely on the fiscal side. The QE boogyman is a non-issue.

    Also, don’t forget Goldman and Morgan ARE commercial banks. Investment Banking: June 16, 1933 – September 21, 2008. RIP. ;)

    • 1. When the Fed buys assets it does so with newly printed money. So in that way it pumps up the money supply.
      2. I would agree in general on tax cuts. But Keynesian fiscal stimulus achieves nothing. Ask the Japanese.
      3. I disagree with your bottom line. Business cycles are a function of money supply.
      4. You can’t get a loan or checking account at your neighborhood investment bank. There is a big difference between merchant banking and investment banking.

  • Buck

    1. Agreed! Fed creates reserves ex nihilo; money ‘supply’ is increased; Instantaneous ‘inflation’ (for Austrians). Inflationary ‘impacts’ (for Earthlings) remain quite subdued since ‘supply’ was merely swapped for existing ‘assets’ (i.e. no decrease in debt ratios). Continue to witness this (non-event) unfold.

    2. Agreed! However, not ‘everything government’ is ‘Keynesian’, nor is every method the ‘Japanese’ method. Otherwise you obligate yourself to ask the Japanese how much inflation their 600% QE bought them.

    3. Agreed! Cheap money equals malinvestment. See Minsky also. The bottom line still holds though. Admittedly I should have been more clear about the caveat “(in times like these)”. During periods of relative normalcy, yes, the Fed is doing most of the ‘affecting’ by setting the price of money. However, knee-deep into the world’s greatest debt deflation monetary policy, including QE, is far to blunt and impotent an instrument. We have witnessed this play out. We will continue to witness this play out until such time that greater fiscal response is ‘demanded’ from the Government.

    4. Agreed. What I meant to say was that Goldman/Morgan are ‘not’ investment banks, as they are now bank (commercial) holding companies. It was more toungue in cheek noting the pathetic loophole that saved them from their deserved collapse. I understand the difference (commercial/merchant/investment).