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Can Pent Up Supply Overcome Systemic Inaction?
January 16, 2012

Life will find a way.

Jurrasic Park

In this issue of The Institutional Risk Analyst, IRA CEO Dennis Santiago looks at the continuing retreat of private capital from the US economy and discusses issues facing Main Street's commercial bankers and Wall Street's capital formation specialists. Using the powerful resolution of IRA's Bank Monitor, Dennis extracts and explains his take on the numbers that continue to move our private economy -- even as policy makers seem oblivious to the inevitable.

As 2011 drew to a close I had a most interesting conversation with a very well-known investment banker. It concerned the continued dearth of new capital formation in the financial markets. Where did the private capital go? Are investors nervous? My glib answer was that beyond the castle keeps of the Hudson and Potomac, people weren't so much nervous as peeved. But returning to what is a very serious situation for all Americans, it is important to look at how Main Street is acting as an independent force in the evolving process. We do this not so much by watching news soundbytes, that's just noise about noise. No, to see the tidal forces at work that will get us all to a better tomorrow, you need to follow the money.

First let's look at evidence of the investor rejection of financial markets. You can see this most by looking at deposit accumulation trends at U.S. banks. This is capital coming out the markets being stuffed into matresses. It's no small amount, just under $3 trillion. And remember a deposit dollar is as close to $1.00 that's worth $1.00 as you'll find these days in the world of investing. Further notice that almost all of the deposit accumulation in the past few years has gone into the over $100B TBTF banks. Deposits at the smaller entities are flat and movement there has been from time deposits to checking and savings accounts as CD's have become less attractive. From an economic perspective, this amount of cash sitting on the sidelines represents a substantial migration of capital from Main Street investing in favor of sheltering assets in FDIC insured banks, what are now some of the most government supported businesses on the planet. That change in investor risk appetite takes a lot of accelerator effect out of corporate America and the ripple effects include withdrawals of IPO Registrations (Form RW) and Exchange Delistings (Form 25) as monitored by IRA's SEC Filings cataloging tools.

So what do banks do with the influx of cash? In the case of the big banks, they plow some of it right back into the financial casino and not into job-creating investment on Main Street. Washington and Wall Street are only too grateful for the risk-aversion of investors as it helps them extend the timelines for resolving legacy issues in areas such as residential housing and thus keep kicking the proverbial can down the road. For some skittish banks, securities have replaced lending as a vehicle for banks to deploy liabilities in an economy where investing in Main Street is viewed as being too risky. The question that should be asked is does this really make sense on a marginal return basis? Or is the internal portfolio allocation at work more of a matter of old habits that die hard?

Let's look at the relative worth of differing sources of income. As you can see, interest income on lending far surpasses the magnitude of other forms of income generation in the banking industry. It holds true across the industry. Notice that the super large banks make roughly the same amount of aggregate lending interest income as the remainder of the industry, around $200B/yr. Policy makers take note. This parity of magnitude implies both groups are equally important as far as Main Street's recovery is concerned. Also notice that interest income from loans and leases has been declining. That's visible shrinkage in the very core of continuing operations of the banking system. See how the other sources of income that are captive to prevailing interest rates are running flat to slightly negative as time goes on? One can income smooth by doing accounting shifts of reserves back from the balance sheet to the income statement to make expected earnings but we all know that's ultimately a dead end. The solution is to get banks operating and growing at economically sustainable margins again.

One thing to notice about securities income with respect to securities holdings is that the gap in growth slope in securities holdings by the over $100B banks has been departing from the income stream's slope for sometime. Some of what's driving this divergence is subjective. Fear over the value of real estate values declining precipitously, fear over obligors defaulting strategically. These fears create greater and greater leverage inherent in the system. We've been down that road before.

Other factors are infrastructural. Some banks have winnowed down their lending operations. As pressure to lend anew rises, they'll have a caseload capacity problem made worse by more stringent regulatory rules that have to be met for each new loan. Some even have internal policies to not engage in new lending and "ride out" the storm. These decisions by bank management means that these banks are effectively running a low yield mutual fund investing predominantly in low ROI risk free securities. Yes this does take these banks out of play for contributing actively to Main Street's economic recovery in the present. Whether that turns out to be a prudent business strategy remains to be seen but they are running the risk that other more aggressive banks that are working the fields now will be significantly ahead of them when they do come up for air.

All of this adds up to a pent up supply of deposits on the liabilities side of the balance sheets available to lend. To track presure on this supply we've broken the banking population into two groups. One group has business operations that are dominated by commercial/retail lending and the other are banks that have significantly elevated portions of their assets devoted to securities and trading. We set the division at 60% lending as a percent of asset base and had IRA Bank Monitor extract the average deposit dollars per lending dollar figures for these banks over time.

I wrote a layman's piece on the Huffington Post almost exactly a year ago lamenting "A Deepening Dearth of Lending". The numbers say things haven't improved. Among lending emphasis banks, there's been a universal migration to higher levels of deposit surpluses. Most dramatic are the larger banks that used to run aggressive leveraged lending engines that were only partially supported by core deposits. These banks are now straddling the 1-to-1 ratio boundary between loans and deposits, an extraordinary development which illustrates the still-strong deflationary bias in the US economy. The smaller institutions have even greater idle deposit ratios, which means that the net deposits above amounts required to fund lending are going into government bonds. This tendency manifests in the marketplace with fierce competition for the lending deals that are available. The competition often involves loss leader bids by banks large and small, all seeking to book an incremental addition to their performing loan portfolio. Remember that most banks in the US today are seeing more old loans being redeemed than new loans made, meaning that net credit available to the US economy is shrinking.

The story among the non-lending emphasis banks is a mish-mash of asset strategies. They include Wall Street critical investment banking houses and brokerage funds parking lots. For the most part, these institutions are more exposed to market rate risks as well as instrument reinvestment risks on their portfolios than to credit risk. They react with more volatility to certain types of economic stress scenarios versus their lender business model peers. Their assets tend to interact only indirectly with Main Street. However some of them are critical players to the capital formation process and aren't exactly thrilled with where that line of business is heading. Which gets us back to the conversation that started this article.

The data brings up some important questions worthy of follow up by policy makers and business operators alike.
  • Have the operating deposits-to-lending ratios of our Main Street financial institutions migrated to levels that impede our economy's ability to recover? If so, what should be done to maneuver the ratios to more appropriate norms? Is the Fed's zero rate posture helping to stem the flight of capital from Main Street or making things progressively worse?
  • For the non-lending emphasis elements of our economic engine, do we have appropriate guidance for them? Specifically, how to make sure that we design a system of solutions which orchestrate a "greater than the sum of the parts" outcome for the nation?
  • Has the amount of money that as shifted away from capital markets and new capital formations in a flight to quality placed our economy's ability to innovate domestically and compete globally at risk? Is this risk a strategic enough concern to treat it as a national interest issue? If so, how do we ponder and organize to work on a solution?
  • While it's probably easier and more productive for economic recovery to focus on the lending heavy operations first, is it still appropriate to work the problem piecemeal or is getting all parties to work together the best way to get to yes?
  • And perhaps most important of all, can we design the solution that is fair, equitable, believable and explainable to the American people?

Questions? Comments? info@institutionalriskanalytics.com


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