The Problem With the Banking System

Since the height of the U.S. financial crisis in 2008, bank-lending has been stagnant even as the monetary and fiscal stimulus enacted to counteract the contraction in private sector economic activity has been the greatest in U.S. history. This has led to speculation about whether the stimulus has been large enough to be effective, whether more is necessary, and whether it will work. There have been accusations that the banks, especially the money centers, are now essentially government-supported hedge funds and not lenders.

These are worthy topics concerning the failure of the private sector and bank-lending as the theory has promised they would to the level of fiscal and monetary stimulus provided. The discussion, though, takes for granted that the 2008 crisis and resulting stimulus is the genesis of the problem -- that something may have structurally broken in the banking system because of Lehman Brothers' demise and associated failures at the time.

But there is a problem with this scenario in that it doesn't match the reality that bank-lending, as a percentage of assets, has been declining for about 10 years in aggregate. That means that not only has bank-lending been declining in importance as a revenue and profit center for banks, but it was doing so even during the peak housing years of the mid-2000s.

Citigroup's (C ) net loans as a percentage of total assets were at a trailing 10-year peak of about 64% in 2003. It declined slowly but steadily from there by about 2 percentage points per year and abruptly fell to about 42% in 2009, about where it has remained since. Bank of America's (BAC) trailing 10-year high was also 10 years ago at about 60%. It fell to about 50% by 2005 and has been range-bound between 50% and 55% since. Wells Fargo's (WFC) trailing 10-year high was achieved in 2005 at almost 80%, by far the highest of the money centers and indicative of their almost singular focus on residential mortgage origination. From there it has declined steadily to about 60% today, even though it dominates the mortgage industry. JPMorgan Chase's (JPM) trailing 10-year high was at about 42% in 2004 and it has since declined to about 35%.

The point is that the trend toward lending as a shrinking part of banks' core operations has remained steady throughout the real estate boom, bust and various financial and regulatory corrective measures since. The pattern is not as uniform across all banks in the national, regional and local segments but it is still there in aggregate. The point is that the problem with the money centers not lending may not be that they are "too big to fail" but just that they are doing what all banks are now allowed to do -- something other than loan money.

The genesis of the transition away from banking and toward other revenue and profit-generating areas appears to be the passage of the Financial Services Modernization Act of 1999 that repealed the Glass-Steagall Act of 1933, which had precluded securities firms, commercial banks, and insurance companies from combining. Although the rescission of Glass-Steagall has been considered by many as a prime catalyst for the breakdown in mortgage underwriting that was at the heart of the subprime debacle, there has been little talk of it as the reason for bank-lending to have declined.

There is the appearance, though, of a transmission system breakdown between the Federal Reserve and the banks, but that may be caused by banks being afforded to do things with capital supplied by the Fed that they would have been precluded from doing prior to 1999. The Dodd-Frank Wall Street Reform and Consumer Protection Act was intended to make "too big to fail" implausible through regulation of activities rather than precluding them as Glass-Steagall had. Vermont Senator Bernie Sanders introduced a bill to break up "too big to fail" banks but he does not call for the securities, banking, and insurance operations to be separated again.

If the trajectory toward bank-lending as a percentage of assets continues, it is logical to assume that soon Glass-Steagall or something similar will be required to get banks back to the business of lending.

At the time of publication, Arnold was long JPM Bonds.