Monday, August 6, 2012

Risks Associated with Investing in Commercial Banks

If I thought I was a “value investor” and that my investments should be held, at a minimum, for four or five years, I would not want to put any of my investment money in commercial banks at this time.

The primary reason for this is the uncertainty that envelops the banking industry at this time.

First, there is still, I believe, a great deal of uncertainty about the value of many of the assets banks are carrying on their balance sheets.  Let me just mention three areas of concern: commercial real estate loans; residential real estate loans; and anything connected with state and local governments. 

Commercial real estate loans have generally been granted with a five to seven year maturity with the principal of the loan coming due when the loan matures.  Many of these loans are coming due or will come due in the next 12 to 18 months.  Most of these loans will need to be refinanced.  A large number of the projects connected with these loans are not doing well.  It is uncertain what will happen here.

Current statistics on residential real estate loans indicate that about one in four of these loans have a mortgage value that is in excess of the market value of the underlying property.  The government would like to see many of these loans refinanced with the principle amount of the loan being reduced to a value below current market values.  This may help the borrower but it would require substantial asset write-downs for the financial institution holding them.

In terms of state and local governments very little needs to be said these days.  Every week it seems we learn more about the financial tricks these governments used and the unfunded pensions that exist, which cannot easily be covered.  No one seems to have an idea about how much these problems will impact our commercial banks.

Second, there is the uncertainty hanging over the banking system about the new rules system that is going to be imposed.  President Barack Obama signed the Dodd–Frank Wall Street Reform and Consumer Protection Act into law on July 21, 2010.  That was two years ago!

And, banks still don’t know what some of the laws are and how they will be implemented.  One reason for this is that there are still a number of the provisions of the law that have not been fully written yet.  Dates still get postponed for when various provisions will actually be implemented.

Then we have the Basel III rules, imposed by international agreement, that remain to be implemented. 

I don’t know one banker that is happy with this situation. 

Third, there is the uncertainty with respect to the state of the economy.  Very little is happening in the economy.  Economic growth, year-over-year, remains around 2 percent and is not expected to get better in the near future.  The reports are growing about companies that are cutting back spending because of the uncertainty created by the “fiscal cliff” coming up. And, there is uncertainty about how the economic crisis in Europe is going to play out in America.

Finally, there is the uncertainty surrounding the future structure of the banking system.  Although there has been so much noise about banks that are “too big to fail”, the larger banks continue to dominate the banking scene and will continue to do so in the future. 

The largest 25 banks in the United States plus foreign-related financial institutions hold more than 70 percent of the banking assets in the country.  This number is only going to increase. 

Domestically chartered banks that are larger than $1 billion in asset size (there are 525 of them) hold more than 90 percent of the assets held by domestically chartered banks.  This means that there are about 5,700 banks in the United States that hold less than 10 percent of the banking assets in the country.

And, we hear and read about the pressure that the bad bank assets, the poor economic conditions, and the growing regulatory burden are putting on the smaller banks.  Take for example the Wall Street Journal article, "Small Banks Are Blunt In Dislike of New Rules".  This is an article about how these bankers are reacting to the proposed rules on capital levels related to Basel III. 

The most important, to me, paragraph in the whole piece is the last one.  “C. R. “Rusty” Cloutier, president and CEO of MidSouth Bancorp, Inc., of Lafayette, La., said the Basel rules won’t affect him as harshly as some smaller banks since he is on the big end of small—about $1.5 billion in assets—and publicly traded.  But his phone is ‘ringing off the hook’ for smaller lenders looking for an exit.” 

Everything today points to larger banks and fewer smaller banks.  And, it is not just the economics that is pointing this way but the actions of the politicians and regulators are also driving things in this direction as well.

But, there are two other major players that have to be contended with in the restructuring going on:  credit unions and “shadow” banks. The roles these two categories of financial organizations are going to play in the new structure are uncertain now, but they will be important players, I am sure of it.

For one, people needing “banking services” are going to divide into two sub-groups.  Those that don’t need “traditional” banks…like myself…who can do all they need electronically and interact with all their assets within the same institution.  And, those that basically only need a checking account, a safe deposit box, and maybe a savings account.  This latter group needs a “no frills”, low cost provider of basic banking services.  The credit unions may eventually satisfy this need. 

And, lending is going to change for small business.  Angel financing is going to grow.  Private equity is going to play more of a role in business lending and then there are other innovations like “peer-to-peer” lending and so forth.  No telling what is going to evolve from the Internet.  No telling what will come from the shadow banking system.  Depository institutions need not apply.

In five years, banking finance will be structured in a very different way.  Getting there will be the problem.  Because of the uncertainties mentioned above, investing in commercial banks will make it very difficult to pick winners.

At the start of the year, who would have picked out JPMorgan Chase as the institution that would “shock” the banking industry with trading losses?  Myself, I am not confident that any bank in the present environment is immune from such surprises.  Banks may have bad assets on their books that have not been recognized.  Banks may be unprepared for exactly how the banking regulations are going to work out.  Banks may not whether this period of slow economic growth well.  And, banks may not be fully prepared for the changes taking place in information technology and the new competition from shadow banking and beyond. 

These are new times.  There will be new “winners.”  And, there will be lots of losers.  Welcome to banking in the early twenty-first century!

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