The Economy and the Stock Market

Yesterday, I wrote about the prospects for economic growth through the end of 2013. (See http://seekingalpha.com/article/437481-economic-recovery-the-good-and-the-bad.)  Today, I connect this picture of the economy over the next twenty-one months with the performance of the stock market. 

This has been an interesting week for the United States stock market.  The S&P 500 closed above 1,400; the Dow-Jones index closed above 13,000; and NASDAQ closed above 3,000.  The stock market seems to be headed upwards.

The question needs to be raised about whether or not a rise in the stock market can be considered to be consistent with my view of the economy through 2013.  Yesterday I wrote that I believed that real GDP in the United States would grow over the next two years or so in the range of 2 percent to 3 percent, year-over-year.  My basic feeling is that the growth rate will tend to be closer to 2 percent over this period than to 3 percent. 

There are a lot of “unknowns” that could affect this outcome, but it appears to me that the policy makers, at least those at the Federal Reserve, have taken many of these into consideration, thus these “unknowns” are “known” unknowns, and are attempting to error on the side of too much “ease” to prevent the economic system from being “shocked” or “surprised” in a way that will block the recovery. 

One, of course, can never be fully prepared for a war…in the middle east…or an economic collapse…elsewhere.  If something like this were to occur then all bets are off.

Thus, the underlying picture of my economic forecast is that the monetary authority will err on the side of ease and the fiscal policy of the United States government will be…vague…but will pile up deficits in excess of one trillion dollars for the foreseeable future. 

The immediate question this raises in my mind is that of financial bubbles.  Over the past two years or so there has been considerable concern about the funds the Federal Reserve has pumped into the banking system.  In November 2009 excess reserves in the commercial banking system exceeded $1 trillion and has remained above this level ever since.  The latest Fed data show that excess reserves now stand between $1.5 trillion and $1.6 trillion.

Given this liquidity in the banking system and the consequent low interest rate targets the Federal Reserve is working off of, a considerable amount of concern has existed over the past two years or so about bubbles being created in various markets around the world, like commodity markets and the markets for the securities of emerging countries.  This concern still remains.

If there have been bubbles in these markets, could we not assume that  a bubble might exist in the United States stock market as well?

Robert Shiller of Yale University has produced a statistic that he calls CAPE, or, the Cyclically Adjusted Price Earnings Ratio, related to the United States stock market.  The basic idea presented by Shiller is that this ratio will vary cyclically but will tend, over time, to eventually revert to its mean average.  The long-term average of ration is around 14.0. 

In February, CAPE, as calculated by Shiller was 21.64. (Note: Shiller delivers these data “on line” for free on his website http://www.econ.yale.edu/~shiller/data.htm.)  Hence, the current level of the CAPE measure is substantially above its long-term average.  One could say that it is about 50 percent above its long-term average.

Before one jumps to the conclusion that I believe that the market is way “over valued” and needs a correction, let me say a couple of things.  First, as Shiller, himself, states, CAPE can stay over or below its long-term average, in fact it can stay way over or way below its long-term average, for a long time.  Being over or under the average does not mean there will be an immediate reversion to the mean.  In fact, it can stay over or under the mean for longer than you can afford to hold a position betting against it.

Second, if CAPE is over or under the mean, it is important to try and understand why it is in such a position.  For example, because CAPE is adjusted for its variations over the longer-term it tends produce some lags in its response.  In this case, the earnings variable is lagged over an extended period of time and will therefore tend to be somewhat “behind” the cycle.  Thus, if stock prices rise in anticipation of a growth in earnings, the ratio may tend to rise ahead of earnings growth with the idea that it will fall in the future as earnings actually catch up with the expected earnings captured in earlier price increases.  In cases like this the cyclical behavior of earnings will eventually bring CAPE into line with its longer-term average.

However, if there is a bubble in stock prices, the earnings will not catch up with the initial rise in prices and the stock prices will eventually have to fall to bring CAPE back into line with its long-run average.

One can look at other factors in the financial markets in an attempt to determine whether or not CAPE will revert to its mean sooner rather than later.  There are two particular measures of financial markets that I have worked with in recent years that provide some help in understanding the performance of the stock market.  The first I call a confidence index and the second I call a liquidity index. (I will explain these two measures in future posts.)  If both indices are rising, then the S&P 500 index tends to show pretty good gains, 10 percent or more, and CAPE can be expected to remain where it is for the time being.  If both decline, then the S&P 500 index will fall, 10 percent or more, and CAPE can be expected to revert toward its mean.  If the measures are mixed then the S&P 500 index seems to fluctuate over and above a zero-growth rate. 

Last year this confidence index reached a near term peak in June and declined throughout the summer and fall until February this year.  It has since risen into the middle of March.  The earlier period coincided with a lot of uncertainty in the US economy and with the rising concern about the European sovereign debt situation.  The pick-up in confidence came about as economic information seemed to improve and as the situation in the eurozone with respect to Greece improved.

The liquidity index dropped through much of 2011 and bottomed out in December.  This index has been rising since then into the middle of March.  The decline occurred because so much money went into Treasury issues from other issues in the financial markets, a “move to quality”.  Over the past few months we have seen a reversal in this as funds have flowed back into these other issues making the market, as a whole, more liquid. 

So, right now, I believe that the US stock market is in for some further upward movement.  I expect to see the economy continue to grow…although modestly…and I expect that monetary policy will remain on the side of cautionary ease…but, we will not see QE3.  Measures of financial market confidence and liquidity are both positive and I am expecting they will remain so in the near term.  This means to me that even though CAPE is above its long-term average it is in no danger of dropping due to the price of stocks falling to bring them back into line with the long-term movement in earnings. 

My best guess for the stock market, then, baring any unforeseen shocks, is for the S&P 500 index to rise by at least 10 percent, year-over-year, for the next eighteen months or so.    

Economic Recovery: the Good and the Bad

The economic recovery began in July 2009.  Since then we have been plagued by a plethora of good economic news and not-so-good economic news.  David Wessel, in the Wall Street Journal, captures this continuing saga in “An Economy Poised Between Flight and Fright.” (http://professional.wsj.com/article/SB10001424052702303863404577281210187996478.html?mod=ITP_pageone_1&mg=reno64-wsj)

It has become obvious to many that the current experience is not that of a conventional business cycle.  The economy is recovering but the pace is extremely slow and the fragility of the recovery is obvious to almost everyone.

Major focus has centered on the banking system, the housing and the household sectors, and labor markets.  These worries translate into issues of solvency and deleveraging. 

On top of this is the tension over Iran, Syria, Afghanistan, the rising price of oil, and the financial difficulties of the eurozone. 

The important thing, to me, is that the economy is recovering.  The second most important is that the major problem areas the world is facing have been identified.  Given these two factors, the major policy issue faced by the monetary authorities…and the fiscal authorities…is to avoid further unexpected shocks to the system.

For one, the Federal Reserve is dealing with a very fragile banking system.  Last year, 240 commercial banks left the banking system or were closed.  The pace of bank departures seems to be less this year, but the number of banks in existence still seems to be declining quite rapidly. 

The Fed has been keeping plenty of liquidity in the banking system so that the FDIC can continue to oversee the continued decline in the number of banks outstanding in a smooth and continuous way without disruptions or shocks that could cause a further unsettling of the financial system.

With all the restructuring going on in the banking industry, coupled with the new load of banking regulations banks are facing, loan growth had remained tepid or non-existent until just recently when banks started to extend credit at a faster pace.  I take this as a good sign and an indication that the bankers are growing a little more confident. (http://seekingalpha.com/article/426601-finally-some-real-loan-growth-at-the-banks)

But, deleveraging in the private sector, especially in the United States, has continued.  Major debt cycles take a long time to unwind.  We can be thankful that major debt cycles only occur about once every century for the working off of debt overloads can take a extended period of time and distract attention from productive activities like manufacturing and construction.

This deleveraging is taking place and, I believe, will continue to take place.  Martin Wolf, in the Financial Times, gives us a good summary of how deleveraging is unwinding. (http://www.ft.com/intl/cms/s/0/07b419ac-6c39-11e1-8c9d-00144feab49a.html#axzz1pCcr5QXS)

The major takeaway from these examples is that things are improving and the economic recovery is coming along.  Sure, there are going to be bumps along the road.  Sure, there could be some surprises that could sidetrack us.  But, it seems as if people are focused on what things could go wrong and are over-compensating for these possible events so as to avoid surprises.  That is, major attention is being given to identify “known, unknowns” so as to minimize the “unknown, unknowns.”  It is the “unknown, unknowns” that are the most dangerous things, the things that can really divert the economic recovery.    

I believe that the Greek debt restructuring went as well as it did because most of the “unknowns” were on the radar of the participants of the financial markets so that the financial markets reacted smoothly to the settlement that took place.  In essence, there were no surprises. (See my post “The Greek Situation: The Financial Markets Do Not Like Surprises” which was posted on March 12, 2012, http://masefinance.blogspot.com/.)  It doesn’t mean that everything is settled, it just means that nothing disruptive happened.   

So, I continue to argue that the economic recovery will continue, but the growth rate of real GDP in the United States will remain below 3 percent for a while as the deleveraging continues to take place at a reasonable pace.  Whether it will be between 2.5 percent to 3.0 percent as projected by the Federal Reserve or remain around 2 percent or below, as forecast by the Congressional Budget Office, is anyone’s guess.

As I mentioned above, however, the modest increase in commercial bank lending is the most positive sign I have seen for a while.  Right now, I am leaning toward something above 2 percent but below 3 percent through 2013.  Good, but still not robust. 

Given this picture, the major problems I see on the horizon are two.  First, I am worried that people in Washington, playing for a political advantage, will still feel the need for additional budgetary stimulus in one way or another.  I believe that this would achieve very little in the way of greater economic growth because the private sector will continue to deleverage and so the multiplier of any additional government programs would be less than one. 

Second, the Federal Reserve must deal, at some time, with all the excess reserves it has injected into the banking system.  The dilemma here is that the banking system is still fragile and the FDIC needs further time to help the banking system get smaller in number of banks in existence.  On the other side of the equation, however, is the fact that at some time the excess reserves can turn into kindling for the inflationary fires.  That is, loan growth could become excessive.  In this latter instance, given the current state of the economy, I can see inflation becoming more of an issue without any consequent improvement in the rate of growth of the economy. 

The economic system is still very fragile…but the economy is recovering.  For now, I believe this is the best that can be achieved.      

Larger Banks Are Changing the Banking Landscape

In a recent New York Times op-ed piece, the finance blogger at Reuters, Felix Salmon, wrote about the higher fees being charged customers at larger commercial banks in the United States. 

Salmon states, “As bank fees have moved from being invisible to being visible, the inefficiency and greed of the big banks has become ever more obvious.  The result is heartening: In 2011, more than 1.3 million Americans opened a new account at a credit union.

In part that’s because smaller banks and credit unions are a better fit for the average consumer.  They don’t have the huge branch networks to support, they pay their executives mush less and they don’t generally feel the need to be enormously profitable in the first place…

So, rather than kvetch about monthly checking-account fees, let’s celebrate them.  With any luck they’ll be just the thing we need to finally get around to closing our accounts at Citibank or Wells Fargo or Bank of America or Chase, and opening a new account at a better, friendlier—and cheaper—bank.” (http://www.nytimes.com/2012/03/11/opinion/sunday/higher-bank-fees-are-a-good-sign.html?_r=1&scp=3&sq=felix%20salmon&st=cse)

This reminds me of the time I was sitting in the executive quarters of a large savings bank in Philadelphia in the late 1970s.  I was talking with several of the senior people on the retail side of the bank.  They were ecstatic about the fact that their bank had just picked up more than 5,000 new accounts over the past month or so from a commercial bank that had recently started charging depositors explicit fees on their checking accounts as well as on some other transactions related products. 

This scene was ironic to me because about a week before, I was talking with some senior executives from the commercial bank that had raised its fees and they were very, very excited about all the accounts they were losing because of the new charges.  They were excited because the accounts they were losing were generally low balance, high transactions accounts…in other words, very costly accounts…and this had been one of the objectives they had hoped to achieve with the imposition of the higher fees.

Note: the savings bank failed while the commercial bank remained healthy and was ultimately acquired by a larger, national organization that was diversifying geographically.

This story came back to me in reading the New York Times article because I see some of the fee activity of the larger banks as an effort to encourage certain bank customers to leave these larger banks and take their accounts to the smaller commercial banks or credit unions. As with the commercial bank I described above, by raising certain fees and charges, these larger banks were allowing their customers to “self select” and take their business elsewhere. 

Of course, some of these larger banks presented their new fees in such a way that they got a lot of unfavorable publicity that they didn’t really want and so they immediately backed off.  And, this news played into the “Occupy” movement and helped its cause. 

But, I would say, the larger banks got what they wanted.  According to Saxon, 1.3 million Americans opened a new account at a credit union.  And, even more opened accounts at “smaller” commercial banks.

What’s going on here?

Well, this is a part of the new, evolving financial system. 

Are the larger banks really unhappy about this movement?  I don’t think so.  The larger commercial banks are getting larger.  The share of banking assets going to the smaller banks is declining.  In February 2012, the largest 25 domestically chartered commercial banks in the United States made up just about 66 percent of the total assets of all domestically chartered banks.  In February 2008, just before the financial crisis took place, the largest 25 banks in the United States held less than 65 percent of the total assets. 

Note: total assets at all domestically chartered commercial banks were just about 13 percent larger in February 2012 than they were in February 2008.

Furthermore, at the end of the year 2011 there were 6,290 commercial banks in the banking system, almost 1,000 fewer than existed at the end of the year 2007 when there were 7,284 commercial banks in existence.  The shrinkage came in the number of “smaller” banks.

But, Salmon writes: “From a consumer’s point of view, this trend (the movement of deposits to smaller commercial banks and credit unions) will create a virtuous cycle.  As deposits leave the big banks for smaller competitors, the too-big-to-fail crew will inevitably lose political clout—and eventually, start shrinking.”

What am I missing here that Salmon sees?

I agree that things are changing, but I see them changing in a different way.  Less wealthy individuals and businesses will move to smaller banks and credit unions.  These people will prosper at not-for-profit, low overhead organizations.  These financial institutions will offer more basic banking products and services and will thrive.  And, their customer base will be very happy. (http://seekingalpha.com/article/420741-commercial-banks-can-t-get-a-break)

Wealthier customers and larger businesses will work with the newly re-structured larger banks.  We see this taking place already as JPMorgan Chase and Citigroup, Bank of America and Wells Fargo are creating new relationships, new branches, and new lounges to attract a more affluent customer.  This new target is the “mass affluent”.   These are people with assets in the “hundreds of millions.” 

This, however, is not just about “banking” but about mutual funds, stocks and retirement advice and so on and so forth.  This approach is providing the customer with complete, timely, fluid, low cost management of the “customers’” wealth.  These banks are not going after the top 1%, but they are going after the top 10%.

Not only are these accounts more lucrative, they “also face less of a pinch under new government regulations than do those of ordinary savers.” (http://www.nytimes.com/2012/03/11/business/to-increase-revenue-banks-go-after-affluent.html?scp=6&sq=nelson%20schwartz&st=cse)

And, what kinds of managers are being brought into these banks by the Board of Directors?  Not just commercial bankers, oh, no!  Commercial bankers are just “debt” guys…people that only understand advancing money if there is adequate collateral and don’t get all agitated if the borrowers credit rating is not the best.  They understand loan classifications like business loans, mortgages, consumer loans, and commercial real estate loans.     

No, the recent trend…although it is not absolute…is to bring in investment bankers at or near the top.  Investment bankers are “equity” guys…they understand ownership…and, they understand risk management.  And, they understand asset classes and portfolios of assets. (http://www.ft.com/intl/cms/s/0/0e80a8c6-6c6c-11e1-b00f-00144feab49a.html#axzz1p1BAmhf3)

So, we should celebrate, with Felix Salmon, the movement of small deposit accounts to the smaller banks and credit unions.  However, I am not sure that I am celebrating this movement for the same reason that he is.   

The Greek Situation: Financial Markets Do Not Like Surprises...and Vice Versa

Greece had a credit event.  Credit default swaps were triggered.

Markets opened.  Markets functioned.

This morning, the “new” Greek debt was trading at distressed levels…just below 20 percent.  The read of the market, “investors are braced for more distress.” (http://www.ft.com/intl/cms/s/0/d5440e3c-6c29-11e1-8c9d-00144feab49a.html#axzz1ouHDWdzj)

But, the world did not end. (http://professional.wsj.com/article/SB10001424052702304537904577275462837459448.html?mod=ITP_opinion_2&mg=reno64-sec-wsj)

Concerns still remain about Greece and the Greek government: “Most investors remain deeply skeptical of Greece and the sustainability of its debt despite Athens shaving off €100bn, or nearly a third, from its debt burden in last week’s successful bond swap.”

Financial markets are going to want to test this.  And this may mean that the “downside” of the pricing of Greek bonds may initially be pushed to see how firm it really is.  Whether or not the downside holds will depend upon what the Greek government does in upcoming weeks and what the eurozone does with respect to its lingering problems.

This concern does extend beyond the Greek situation in that the yield on the 10-year government bonds of Portugal, the country deemed most likely to follow the example of Greece, remains near the high levels reached in the recent unsettled weeks.

This situation, I believe, raises the question as to whether or not the actions taken by Greece are strong enough and will the Greek government actually be able to carry out everything that is needed to resolve the Greek insolvency.

Markets do respond positively to “credible” actions on the part of national governments.  For example, the “technocratic” government put into place in Italy seems, at least for the time being, to have calmed the international investors.  In November 2011, the 10-year bond of Italy was trading to yield around 7.30 percent.  A 7.00 percent yield was declared to be unsustainable for Italy.  Currently, this bond is trading below 5.00 percent, indicating that there is some trust that the present Italian government will achieve what it is attempting to do.

We will, of course, see whether or not these “expectations” play out.

But, as the editorial in the Wall Street Journal suggests, “the world did not end” with the Greek restructuring.

My response here is that markets do not stop trading when events are not surprises.  Markets hate surprises and when they are surprised…trading stops.  In such situations, traders don’t know where to set prices.

We can have policy surprises.  I was at the New York Fed one time when the Federal Reserve decided, for international reasons, to reverse the policy they had been following that had resulted in short term interest rates declining.  The fact that the Fed wanted short term rates to rise and therefore did not intervene when market pressures pushed these rates higher caused the financial markets to pause…trading stopped for a while.  Expectations had been broken and traders had to reset them before trading began once again.

Another example of a “liquidity crisis” is when the Penn Central Company failed.  Here was an example where the market perceived that the Penn Central had top rated credit and expected that the commercial paper issued by this company would be rolled over without any problem.  When the company declared bankruptcy it was a shock to the financial markets because the traders not only had to deal with this new information about the Penn Central itself, but also questions arose about the credit ratings of other highly regarded companies. 

The Federal Reserve had to react to this liquidity crisis by “throwing open the discount window” and other measures to provide market liquidity until traders could feel confident in starting up trading once again.

The recent “unexpected” event that surprised the financial markets and provided the background for the current concern over the creation of another “credit event” was the failure of Lehman Brothers.  Financial markets did not expect the United States government to let Lehman “go under”.  When the government did allow the company to “go under” people were not really prepared for this event…they were “surprised”.  And, systemic risk was released that caused substantial disruption to United States and European financial markets.

Great concern has been expressed in Europe (and elsewhere) that a Greek “credit event” that triggered the payment of credit default swaps could set off systemic effects that would spread from Greece to Portugal and possibly Spain…and Italy…and other countries. 

My feeling is that this concern was excessive.

The Lehman Brothers “event” was not expected.  Since people were not really prepared for the “event” adjustments had to be made, financial positions had to be altered, and, expectations had to be changed.  And, this transition had to take place throughout many, many organizations.

In the current Greek situation, the action taken last week was not un-expected.  Financial markets were prepared for it.  And, the financial markets absorbed the “shock” without much problem.

I believe that financial markets do work and do work well if they are not surprised.  This is why, in my mind, financial markets handled the Greek bond-restructuring program as well as they did. 

I am not convinced that politicians and government officials understand this.

Also, I am not convinced that politicians and government officials understand that their failure to fully resolve issues can create “sure-thing bets” in financial markets.  That is, if the Greek government does not fully execute the restructuring plan and carry out the promises it has made, a lot of people will make a lot more money by continuing to bett against the Greek government.

Just ask George Soros about the British government setting up “sure-thing bets” by trying to maintain the value of the pound in the 1990s.

Finally, Some Real Loan Growth at the Banks

It finally looks as if the commercial banking system is starting to do some serious lending.  My last review of the banking statistics focused on the continued flow of funds in the United States banking system to foreign banks and then to deposits in the foreign offices of these banks. (http://seekingalpha.com/article/344571-developments-in-the-banking-sector-still-flowing-to-foreign-institutions) 

At the time, this flow of funds dominated everything else going on in the banking system…especially the lending activity. 

There had been a little pick up in commercial and industrial (business) loans at the largest 25 domestically chartered banks in the last quarter of 2011, but the increase was not too exciting.

Over the last two months or so, business loans at commercial banks have picked up more steam and a good portion of the increase has come at the other (approximately) 6,265 “smaller” commercial banks in the banking system. 

Also, commercial real estate loans and residential loans (home mortgages) showed some strength over the past two or three months at these “smaller” commercial banks.

For the last two years or so I have been looking for some life in the lending portfolios of commercial banks.

I believed that the economy was growing but very modestly.  My concern was that there was so much debt in the economy, household as well as commercial (both in terms of business loans and commercial real estate) that the economy would continue to drag along without much oomph. 

My concern was that households and businesses still needed to do additional de-leveraging before the commercial banks would start lending again and commercial banks needed to start lending again before there would be much life in the economy in terms of economic growth.

Now, I believe, that we are really starting to see some life in bank lending.

Over the past three months, loans and leases on the books of commercial banks in the United States increased by just about $80 billion.  Of this total, $54 billion came in the past month. 

And, to me the surprise in these numbers was the fact that over 85 percent of the increase in these loans came at the (approximately) 6,265 “smaller” banks in the United States.  The totals for these smaller banks were $69 billion and $46 billion, respectively.

Loans and leases on the books of the largest 25 domestically chartered banks in the United States continued to increase over the past three months, but not at the pace experienced by the other banks. 

Not only did commercial and industrial (business) loans increase at the “smaller” banks but there was a pick up in real estate area as well, something that had been sorely missing in earlier.

Whereas commercial and industrial loans at the largest 25 domestically chartered banks rose by almost $26 billion over the last three months, these loans rose by over $20 billion at the “smaller” domestically chartered banks.  In the last month the increase was less that $8 billion at the largest banks and over $10 billion at the “smaller” ones.

The surprise was that commercial real estate loans rose by $17 billion at the “smaller” banks over the last three months while they continued to decline at the largest banks. 

Furthermore, residential real estate loans rose by more than $23 billion at the “smaller” banks in the last three months with $16 billion of this increase coming in February 2012.

To me, this loan growth is GOOD!  It is good for the banks and it is good for the economy.   Let’s just hope it continues!

As far as the foreign-related banking institutions are concerned, cash assets at these banks rose by just about $260 billion over the past twelve months which was 75 percent of the increase in the cash assets of ALL commercial banks in the United States.  This was the concern mentioned in the first paragraph of the post.

The thing about this that we have been watching so closely is that at these banks, Net Deposits to Foreign Offices rose by almost $480 billion during the same time.  The timing of these increases coincided with the sovereign debt problems occurring in Europe and this seemed to indicate that monies being put into the American banking system were being channeled to Europe to help the banks and financial system over there. 

The Federal Reserve System also moved to offset the pressure being felt by the European Central Bank (ECB) and other central banks closely connected to the eurozone by opening up its liquidity swap line with these other central banks. 

Furthermore, the ECB also began to lend on a three-year basis to European banks.   European banks took out more than $1 trillion of these loans by March 1, 2012.

All these actions have resulted in a decline in the cash assets of the foreign-related financial institutions in the United States and basically no change in the net deposits due to the foreign offices of these institutions.  Over the past three months the cash assets of this banks have declined by more than $82 billion, about $52 billion of the decrease coming in the past month. 

So, for the time being, the liquidity problems arising from the sovereign debt crisis in Europe seem to have receded.  However, we will need to keep our eyes on this situation as some pressure is released from the Greek situation and is transferred to other European nations like Portugal and Spain.

So, I am a little encouraged.  But, I don’t want to go overboard in my enthusiasm.  It is good news that commercial bank lending has increased some over the past several months, especially at the “smaller banks”.  It is good news that foreign-related financial institutions seem to have slowed their demand for funds from the United States.  It will be more good news if economic growth accelerates a little bit.     

Commercial Banks Can't Get a Break!

Commercial banks, other than the very largest, just cannot get a break these days.  With their numbers shrinking and numerous loan problems still to be faced, “main street” bankers are facing more and more competition from another group of interlopers…credit unions. 

The commercial banking industry got rid of another bunch of competitors…thrift institutions…and now they are challenged by another not-for-profit upstart. 

In the 1950s and 1960s commercial banks were threatened by the “mutual” savings and loan associations and the mutual savings banks, but the government created credit inflation pushed the thrift industry towards insolvency as interest rates rose along with inflationary expectations. 

The thrift industry was “saved” as numerous savings and loan associations and mutual savings banks converted to “stock” institutions…as it turned out the best thing that could have happened for the commercial banking industry.

Full disclosure: I led the mutual savings bank Wilmington Savings Fund Society (WSFS) into a stock conversion and initial public offering as CFO in the 1980s and I was the President and CEO of a “converted” savings and loan association, First American Savings, into the early 1990s.

The thrift industry, with many of its institutions converted to “stock”, with expanded capabilities of lending and non-bank subsidiaries, basically self-destructed in the thrift crisis of the early 1990s.  The industry never recovered and essentially went out of business in 2011.

Full disclosure: Wilmington Savings Fund Society is still in existence and healthy; First American Savings…or at that time, Flagship Financial Corp…was a healthy institution acquired by PNC bank of Philadelphia in 1991.

Now, the commercial banking industry is being attacked from another angle.  Not only has the credit union industry changed dramatically over the past ten years, but it is healthy and growing.  Some credit unions have been able to shed their very narrow “field of membership” and now have become a significant “banking” force within their local region. 

To re-emphasize…credit unions are non-profit organizations and are tax-exempt institutions. 

They have been very local in orientation and have been very customer orientated.  Many credit unions have specialized memberships either associated with specific organizations…churches, police departments, and schools…or restricted geographical markets.  Also, there are many credit unions that bear a “low income” designation and work closely with local communities in an effort to encourage financial knowledge within the community.

But, some of the credit unions are getting a little pushing.  Now, credit unions are asking for Congress to raise the member business-lending cap for a few of the larger credit unions from 12.25 percent of total assets to 27.5 percent.  And, guess what…the legislation is actually bi-partisan being introduced by the Democratic Senator from Colorado, Mark Udall, and House Representatives Ed Royce, a Republican from California, and Carolyn McCarthy, a Democrat from New York!

The American Bankers Association is against this legislation!  Surprise!

As a backup, however, the American Bankers Association, also signed by 50 state bankers associations, has sent a letter to all House and Senate members arguing that any credit union that obtains increased business-lending authority should pay taxes.

Well, you have to be prepared if you lose the first battle. 

What’s going on here?

Banking is changing.  The big banks are getting bigger and are moving more and more into electronic payments.  JPMorgan Chase & Co., Capital One Financial Corp., and Barclays PLC have moved to let customers use a mobile-payments service. (Wal-Mart Stores, Inc. and Target Corp. along with about two dozen other retailers are working together to develop a mobile-payments system to compete with similar efforts of Google, Inc. and big cellphone companies.)

Note that the banking communities in the developed world seem to be behind those in the emerging nations when it comes to mobile banking. (See “The End of Money” by David Wolman)  One of the leaders in this effort for the less-developed world is the Bill and Melinda Gates Foundation.  Lots of “stuff” is happening here.  And, the technology is there.   

Mobile banking in emerging nations is bringing banking services to the poor and less serviced population in these countries.  But, one of the secrets to this effort is economies of scale.  Mobile banking works best where a “service” has millions of customers, not tens of thousands.

My point is that the smaller banks cannot create such systems.  Furthermore, for the poor or disadvantaged, “commercial, for profit” institutions are perhaps not cost effective.  “Commercial, for-profit” banking institutions are not economically feasible

As we move into the new banking world with the new regulations, I see the industry bifurcating more and more into community organizations that deal with individuals that do not have large asset holdings and primarily need transaction services and places to build up individual/family savings, and larger institutions that are almost totally internet-based that provide a multitude of products and services and allow their customers to transfer funds between classes of assets easily and in real-time.

“Commercial banks” may not be the economically effective way to serve this the former population.  Here, credit unions, mutually owned, may fill in this gap.  The latter market, however, will be served by bigger institutions that allow their customers to manage their portfolios on-line and not work with independent deposits and assets classes, as is now the case.  (There is one question about these larger institutions…will we be calling them “banks”?) 

There will be a third player in this area…the provider of mobile banking services.  These service providers may or may not be owned by a bank but may work with banks much as the credit card companies have.

This is just a simple view of the possibilities for the future.  The fact is that this future is being created right now.  Commercial banks, especially all the ones below the largest twenty-five or so, are under a severe threat.  As in the 1970s and 1980s when the structure of the depository institutions industry was threatened by credit inflation and changes in information technology, the structure of the industry now finds itself under attack from what remains of the financial crisis of the past several years and the changes in information technology. 

Looking back to the 1960s and 1970s who would have ever thought that the thrift industry would disappear?  Now, I believe, we are facing another huge change to the structure of financial firms.  It will be interesting to see what results.   

Bank Regulations Costly to Bank Shareholders

Recently, I wrote a piece on whether or not this is the time to invest in commercial banks. (http://seekingalpha.com/article/389321-with-regulations-in-limbo-this-is-not-the-time-to-invest-in-banks)  I concluded that if one wanted to invest in a commercial bank at this time, the best ones to invest in would be those that are going to be most adept at working around the regulations and the regulators.

Larry Tabb, the CEO of the Tabb Group, reprises another argument about the impact of the “alphabet soup bowl” of proposals and regulations that are now facing the banking industry.  All of this bank regulation, he argues, will impact commercial bank shareholders…and the commercial banking industry, itself. (http://www.ft.com/intl/cms/s/0/695b0230-677d-11e1-b6a1-00144feabdc0.html#axzz1oR0duVqd)

Almost everything the new regulations require will raise costs.  Here are some examples Mr. Tabb gives:

Increasing banks reserves increases the cost of bank capital;

Pushing derivatives towards central clearing leading to  trading on exchanges or swap execution facilities will change how banks charge customers;

The Volcker Rule will push banks from “risk-based profit model” to one based more on transactions fees;

As principal risk is replaced by fees, bonuses and salaries will be cut causing higher-paid individuals to leave the banks;

As banks assume less risk, more risk will be shifted to investors and issuers;

As the fee-based model spreads, banks will become brokers and brokers work off of spreads and this will cause spreads and trading costs to increase;

Widening spreads, resulting in less market liquidity, will increase issuer costs resulting in decreases in turnover and this will result in higher costs for companies and governments to borrow;

More over-the-counter markets will resemble the equities market;

Less regulated intermediaries will come on the scene and employ speed over balance sheet management;

High frequency trading, whose volume comprises over 50 percent of the market, will look more and more desirable because execution is fast and the banks won’t take on much risk;

More limited bank exposure will be hailed because it seems to lessen the need for bailouts;

The risks that are inherent in the newer, less regulated intermediaries will be unknown;

The apparent transparency of these new markets around a centrally cleared market “will only increase the volume in these products.”

And, the cycle will go on!

One does not have to agree with everything that Mr. Tabb presents to come to the following conclusion: the new regulations are going to be expensive and the cost of these new regulations will be carried, ultimately, by the shareholders of the commercial banks.

Furthermore, the new regulations will be the driving force behind a whole new series of financial innovations not unlike those which have “been blamed for the destabilization of the housing market, the instability of European sovereign debt and the ability to manipulate corporate and sovereign borrowing costs and creditworthiness.”

Regulations have consequences.  Mr. Tabb is claiming that the new banking regulations will raise bank costs and create incentives for banks to innovate and work around the regulations.

I have constantly argued that advances in information technology are going to change the structure of banking and finance dramatically.  I firmly believe that the imposition of the new rules and regulations is just going to accelerate this re-structuring. 

 Banking and finance are going to be quite different in the future.  Right now it is hard to tell who will be the winners of the transition.  If history is any guide in this, the future will belong to the newer, less regulated intermediaries than to the entrenched “legacy” institutions.

And, according to Mr. Tabb, “the new rules may or may not preclude another (financial) crisis.”

Stay tuned!