“Them that die’ll be the lucky ones.” (Long John Silver, pirate leader, himself responding to the threat of the Black Spot from his own treacherous brigands, as he storms away from the stockade on Treasure Island behind which Captain Smollett, Squire Trelawney, Dr. Livesey and their few loyal supporters shelter, when they reject his request that they should surrender)
Robert Louis Stevenson, Treasure Island
“Troubled banking industry pulls back: Lending down $587 billion.” Binyamin Applebaum, The Washington Post, February 24, 2010.
The FDIC reported on February 23, 2010 that lending by United States banks fell by $587 billion (or 7.5 per cent) in 2009. This is the largest annual decline since the 1940s. The FDIC also reported that the nation’s 8,012 banks posted an aggregate profit of $12.5 billion in 2009, an increase over 2008, but well below the levels achieved during the mid-2000s. The largest banks accounted for most of these reported profits.
A growing number of smaller banks are struggling to survive losses on commercial real estate loans. Almost 30 per cent of such smaller banks reported losses in 2009, the largest proportion in the 26 years of available data. And the FDIC does not mention that a major collapse in the commercial real estate market is the second shoe about to drop on the teetering US economy in 2010. Regulators shuttered 140 banks in 2009. This number is expected to rise during 2010 with 702 banks considered by the FDIC to be at risk of failure. If the commercial real estate market truly collapses, many more banks assuredly will fail in the absence of bail-out funding. Predictably, the Obama administration is racing to the rescue, with a proposal to pump $30 million in new federal aid into community banks, yet more hard-earned taxpayers’ wealth to be flushed down the toilet.
According to the FDIC, the vast majority of the decline in lending was the result of cutbacks by the nation’s largest banks. These banks have tightened qualification standards for borrowers and increased the proportion of money that they hold in reserve against unexpected losses. FDIC Chairman, Sheila C. Bair, was critical of these actions: “Large banks do need to do a better job of stepping up to the plate here” she complained. The banks cut back most sharply on lending for construction and development, reducing the volume of such loans by 23.6 per cent. Business lending followed closely behind, down 18.3 per cent. Lending to individuals also declined, but more modestly.
I am now going to try to interpret these statistics against the backcloth of the discussion that followed my column dated February 16, 2010, wherein Bill Woolsey took me to task for omitting important considerations. His thoughtful intervention renders my task more complex, but not at all impossible. Among other things, it requires me to make a clear distinction between banks that are illiquid and banks that are insolvent (something that Nathanael Smith and I did in our 2009 book).
A solvent bank enjoys an excess of assets over non-equity liabilities, whereas a non-solvent bank does not. Solvent banks that are also liquid banks hold sufficient reserves of cash , either in their vaults or in the cash reserve at the central bank, to take care of demands made upon such resources. Solvent banks that are illiquid do not hold such a sufficiency of cash reserves. If a financial panic picks up, in the absence of central bank intervention, both insolvent banks and illiquid but solvent banks will be shuttered. The traditional good banking doctrine is that the insolvent banks should go under, but that the illiquid banks should be provided ‘lender of last resort’ cover by the central bank to enable them to mend their over-leveraged ways and to ride out the storm.
The Federal Reserve and the Treasury Department, responding to political pressure from the Bush and the Obama White House, threw good banking practice to the winds in late 2008 and early 2009, and bailed out both insolvent and illiquid banks via massive injections of TARP monies and quantitative easing of the money supply. Subsequently, the Department of the Treasury imposed stress tests on all the major banks to determine whether they were simply illiquid, or possibly insolvent. In my judgment, either the stress tests were rigged, or the Treasury Secretary was duped. Every bank came through with flying colors, although at least 4 of the 10 largest banks – Bank of America, Citicorp, Wells Fargo and GMAC – were and still are insolvent. And several more are teetering on the brink, reliant on the fact that their toxic mortgage-securitized assets are not exposed to market valuations.
Now, let me try to answer two important questions once again: why are the banks not lending? Why has the injection of high-powered money into the system not triggered the usual money multiplier effect? Let me concede to Bill Woolsey the observation that nominal expenditure is running approximately 10 per cent below its long term trend, and that this reflects (at least in part) an upward shift in the demand for money function. Where does this leave us?
In my judgment, a large part of the explanation why the banks are not lending, are not expanding the size of their balance sheets to reflect the insertion of high-powered money, lies on the supply side of the money market equation. The insolvent banks are desperate to pull their chestnuts out of the fire by rebuilding their financial reserves while investing in a limited fashion in Treasury notes as a means of boosting earnings without significant exposure to risk, while they wait hopefully for some of their toxic assets to mature under the security blanket of Obama’s mortgage rescue program. Little or no money multiplier can be expected from these basket-cases.
The illiquid banks are similarly engaged, though with a greater willingness to lend in multiples of their increments in cash reserves. The community banks are shutting down to weather the coming commercial real estate market storm. Yes, the demand for money function has also shifted upwards so that evidence of credit rationing is less pronounced than otherwise would be the case.
Now just suppose, Dear Readers, that all the insolvent banks had been allowed to fail during 2008-9, without any bail-out from the federal government. Suppose that the Federal Reserve had protected illiquid banks by lending at penal rates through the lender of last resort facility, while holding interest rates down through open-market operations restricted to the purchasing of Treasury notes. In such circumstances, new banks would have emerged (always assuming that the Fed allowed new entry into the banking industry) and the insured deposits in the insolvent banks would have found their way into banks that were not incumbered by huge volumes of toxic assets.
The money multiplier would have operated, albeit somewhat dampened by the recession, credit rationing would be much weaker, and private investment would be exerting a much more significant positive effect on the macroeconomy. Surely, banks would not be investing significantly in the construction industry, until the real estate markets have reached full equilibrium. But credit would be much more forthcoming for small firms and new ventures, both of which are capital starved in the current financial climate. Inevitably, the Fed would then confront the specter of inflation. But, without any toxic assets on its balance sheet, it would be able to reverse open market operations to reduce the supply of high-powered money as the economy rebounded to full employment. As Bill Woolsey suggests, the Fed’s interventions arguably should be targeted on some appropriate level of nominal income for the economy as a whole.