As asserted in the mission statement above, this forum concentrates on issues that cross the realms of economics, public policy and investments. Perhaps nowhere is there greater convergence of these fields than in the banking sector. When scrutinizing the challenges facing financial firms, their current activities and performance, as well as investors’ outlook concerning the sector, one can gain greater clarity on issues facing the broader economy. This is owed the sectors’ unique role as the guardian of a country’s savings, while also serving as the transmission channel to allocate capital to its most productive use. As a consequence of the latter, other industry sectors…and the consumer….rely upon banks in order to achieve their own financial objectives. Given this systemic relevance, banking is regulated by myriad government entities, which has famously increased in the fallout of the U.S. financial crisis.
The Motor Oil of a Highly-Levered Society
A primary function of banks is to transmit capital to its most efficient use, meaning they provide the funds necessary for promising enterprises to grow, while at the same time earning sufficient returns to cover the banks’ obligations, such as interest on deposits and payments to bondholders. This role is especially true in a highly-levered society, such as the United States, which despite recent deleveraging by the consumer and the financial sector, has a total debt to GDP ratio in the neighborhood of 300% (with increasing government debt being the culprit for this still elevated figure).
This financial engine has not been running on all cylinders of late. An obvious factor is the aforementioned lower demand by consumers as they continue to dig out from under their inflated balance sheets. Another reason is increased lending standards. An industry adage is that banks lend to clients who don’t need the funds. Although they drifted away from this principle in the lead up to the financial crisis (think liar’s loans, covenant light, etc.), lending standards have subsequently been dramatically raised. As seen below, although loan demand by large and medium commercial customers has returned, lending standards have barely loosened since the peak of the financial crisis.
Data for small business customers have followed a similar path. But given this segment’s dependence on commercial loans for meeting capital needs, the ramifications for these organizations…and the broader economy…are more severe. Large firms are able to circumvent tighter lending standards by accessing the bond market, which is proving especially attractive given the rock-bottom interest rates and demand by investors for relatively safe asset, yielding more than the meager returns paid on government debt. Consequently, bond issuance has soared on this investor demand. Small firms do not have such access to capital markets and are thus more hamstrung by high lending standards. Being that most U.S. jobs are created by small businesses, constricted access to capital is likely one (of many) reasons for the current jobless recovery.
Another reason for lending restraint is that even more so than most businesses, bankers are not fond of future uncertainty and are hesitant to commit capital in such an environment. And if anything, we are currently in an uncertain environment. Not only is the pace of the so-called economic recovery under pressure again for the third summer in a row (thanks to both soft U.S. data and continued bumbling attempts to stanch the European debt crisis), but the industry itself acutely faces an unclear future in light of the colossal Dodd-Frank Bill, which has deferred much of the yet-to-be-defined specifics to regulatory agencies. Since bankers lack clarity on both the direction of the economy as well as the rulebook for their own industry, they have little choice but to horde their massive cash reserves (gifted to them by the Fed’s easy-money policies), in their deposit accounts at….none other than….the Fed, earning 0.25% interest. In nonfinancial parlance, that would be known as peanuts.
Other factors are at play with regard to the current lack of credit flow. Despite substantially cleaning up their balance sheets post financial crisis, loan delinquency rates remain elevated. Also, thanks to the practice of extend and pretend, banks still have pockets of problem loans and mortgages on their books. Further complicating this is the shadow inventory of housing that has been held off the market. Should these properties be released for sale, the subsequent increase in supply could lead to another hit in home prices, thus potentially causing another wave of write downs of existing home loans on bank balance sheets. To complete the feedback to the broader economy (and jobs), many of the aforementioned small business loans are secured by real estate assets. The risk that commercial and residential property prices could take another step back, diminishes their attractiveness as collateral for this business segment, which is so dependent on bank lending.
The Not-So Invisible Hand of the Government
No one argues that there were not credit market excesses during the previous decade. Still one must ensure that the treatment does no more harm than the ailment. The banking industry….albeit deservingly…is under greater regulatory scrutiny. Yet in addition to driving up compliance costs (which get passed onto customers in the form of higher fees), it also ties banks’ hands in many operational and financial matters. Beginning with the TARP program, the government became a significant debt and equity holder of many financial firms. Since the crisis, Dodd-Frank has taken affect, new capital requirements have been dictated by U.S. and international bodies such as the Basel III initiative of global central banks, and specific operations such as the ambiguously-defined proprietary trading specifically in bonds have been curtailed thanks to the Volker Rule. Some banks even must seek permission from their Washington overlords to increase dividend payments; not an insignificant measure given the role the sector has played in dividend investing. And then there is the duplicitous threat of the government suing banks for dubious lending practices at the same time they are lambasting them for not doing enough to aid the economic recovery in the form of extending credit.
All of these initiatives likely have unintended consequences. Ironically, the largest of which may be that in the name of preventing Too Big to Fail, the increased regulatory environment has caused consolidation across the industry. There is now a greater concentration of consumer deposits among the largest institutions, making these behemoths more, not less, systemically important. This was a similar fallout of the 1997 Asian financial crisis. At the end of the day, there were fewer (and larger) banks than there were in the lead up to the crisis. Many argue that the playing field is skewed towards the large banks that have been able to tap government bail-out programs, thus leaving the smaller regional and community banks unable to compete, especially as their expense structure cannot bear the weight of increased government compliance as well as their larger brethren can.
The largest manifestation of the government’s involvement in the financial system is the ballooning of the Federal Reserve’s balance sheet from under $900 billion pre-crisis to $2.8 trillion (thanks to a heavily used printing press). As illustrated above, despite their best efforts to inject liquidity and catalyze lending, most of those funds have wound up back in the Fed’s vaults. As seen below, the velocity (the amount of times money is cycled through the economy) of these newly-minted funds is well below the average of the past three decades, with the Q1 2012 velocity registering 1.58x.
source: St. Louis Fed
One last policy note: as evidenced by a litany of examples over the decades, and most recently by Ireland and Spain, lousy financial sector debt eventually becomes lousy sovereign debt, which in turn drives up government obligations, interest rates and thus borrowing costs for all participants in a credit-dependent economy.
Mr. Market’s Take on the Matter
These issues are linked to financial markets in two ways. First, financial firms remain the second largest sector in the S&P 500 and had held the top spot in the lead up to the financial crisis. Due to this, even passive and indexed investors have significant exposure to banks in their portfolios. Furthermore, pre-crisis, a large portion of dividend payments emanated from the sector. Those disbursements were greatly curtailed as firms struggled to maintain capital cushions and now must meet increased capital requirements. These are the same payments that many institutions must now get the government’s nod before being distributed to shareholders.
The second manner in which markets relate to the banking sector is the verdict investors make when choosing to hold or sell banking shares. Although banks have outperformed the broader S&P 500 over the past two years, one must take into account the depths they reached during the financial crisis. Going back to 2008, banks have substantially underperformed the S&P. Investors, too, are aware not only of the more stringent regulatory environment for banks, but also of the headwinds for economic growth, brought partially about by policies governing other segments of the economy.
Even more than with equities, investment grade bond investors likely have outsized exposure to financial institutions as this segment of the market is heavily populated with lenders, especially as the number of nonfinancial corporations with the highest level of credit ratings has dwindled over the past few years. In addition to contributing less to overall investment returns, banks’ unwillingness to lend may also have the indirect effect on financial markets by removing the so-called private equity put. The concept is that when credit is readily available, shares can only fall so far, before private equity firms will step in to buy the firm at a bargain price, financing the transaction with so-called levered loans. With the possibility of such takeovers diminished, share prices could fall farther than in a less rigid credit environment. Ironically, U.S. banks are increasingly active in the riskier levered loan space, but their clients are European firms that are shunning that continent’s financial sector given the tenuous state of its institutions.
This last point provides an opportune segue to briefly highlight some differences between the U.S. and European banking systems. On the credit side, most financing in the U.S. is raised through the bond market. This was especially true during the securitization heyday. On the contrary, a majority of European enterprises still rely upon commercial loans…which remain on a bank’s books….for their funding. Despite Europe’s dependence on mainstream lending, these institutions actually get more of their funding from short-term wholesale markets than do their American counterparts. On average, U.S. banks have deposits as a larger share of funding than the Europeans. Both systems have their own inherent risks. The ability to securitize credit and sell it off to investors contributed to the credit bubble, which in the wake of imploding, forced many of these same debts back onto bank balance sheets. In Europe, as evidenced by what is occurring now, short-term funding markets can dry up in tumultuous environments, which has led to these institutions' heavy reliance on central bank (ECB) operations to meet their funding needs.