Shrinking Banks

A Capital Mistake


... the nation’s banks are shrinking. At the end of 2008, Federal Deposit Insurance Corporation data showed that the American banks it insured — around 8,000 of them — had $13.84 trillion in assets. At the end of the second quarter of this year, they held a total of $13.22 trillion — a decline of $620 billion.

Fewer assets means fewer loans. From the summer of 2008, just before the financial crisis, to the present, business loans made by American banks declined from $1.49 trillion to $1.175 trillion, a drop of some $315 billion. Mortgages on one-to-four-family homes declined from $2.155 trillion to $1.874 trillion. Over all, the total value of loans in the American banking system has fallen from $7.996 trillion to $7.395 trillion — a drop of $600 billion.

There are many reasons for this. The size of the credit market is smaller today because banks will no longer make risky loans to marginal borrowers. Additionally, commercial companies have seen their cash flows improve because the economy is still growing (albeit too slowly). Therefore, corporations do not need as many bank loans.

However, the main reason bank lending has declined may be that the banks’ capital requirements have increased, and this encourages them not to lend. They certainly don’t have a shortage of capital. The F.D.I.C.’s data shows that the common equity in the banking system — the amount of money invested — as a percentage of all bank assets is now at the same level as it was in 1937. If one calculates what is called the banks’ “capital ratio,” which is done by adding the banks’ reserves and common equity and then dividing by the assets, it appears that the banking system has more capital than at any time since 1934.

Yet banks are sitting on the money rather than getting it out into the economy. Why? Because ever since the collapse, politicians and policymakers have been insisting that risky lending by the banks was the prime culprit, and have demanded that banks build up a cushion of capital to protect the system.

In the past 18 months, in order to meet these demands for higher capital ratios, banks have raised some $192 billion by selling stock — despite declining prices — and attempting to grow earnings. But this has not been enough for the regulators. The banks have also had to shrink their balance sheets — that is, to have fewer loans outstanding.

The trouble with overcapitalizing banks is that when banks cut back on loans, they start a domino effect. When a loan is paid off, money is subtracted from the overall money supply. And while economists can debate whether a growing money supply is necessary for economic growth, it is very unusual for a nation’s economy to grow when its money supply is shrinking.

Comment: A somewhat technical read but interesting. It's related to Fractional-reserve banking.

1 comment:

  1. Related: "Heading into the weekend before the pact, the discussions were focusing on requiring banks to hold basic levels of capital known as "common equity" equal to at least 7% of the bank's assets. This would be up from a 4% threshold imposed on U.S. banks after the 2009 stress tests. "


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