US banking system still badly broken


The Fed Flow of Funds was released on Friday.  If you are interested in finance and you have never seen the Flow of Funds, then you ought to spend a lazy evening checking it out.  The Flow of Funds shows the aggregate balance sheet and funds flow statement of every sector of the US financial system.  For instance, it shows the aggregate balance sheet of all commercial banks in the US.  There are aggregate balance sheets for the household sector, the insurance sector, pension funds, mutual funds, investment banks, and every other major sector.  These balance sheets, of course, show what is owned and what is owed by each sector.  The other half of the flow of funds concentrates not on sectors, but on instruments.  For every major financial instrument a table shows which sectors issue those instruments and which sectors own them.  There is a table for corporate equities which shows which sectors (insurers, mutual funds, pension funds, foreigners, etc.) own all US listed corporate equities.  Likewise, there is a table for the issuance and ownership of corporate bonds, bank deposits, Treasury debt, agency debt, cash, ABS, repos, you name it.  Looking at the Flow of Funds when it comes out each quarter is terrific for developing a sense of what is first order in the US financial system, and also the inter-connections within the finance sectors.

Anyway, the Flow of Funds released on Friday shows that the US banking system remains badly broken.  In particular, the role of bank credit creation in monetary policy is still not working.  Despite the funds pumped into banks by the Fed, bank credit is still shrinking.  In the June Quarter total bank credit fell from $9.53 trillion to $9.38 trillion.  US banks still have $970 billion in their accounts at the Fed — up from $20 billion before the collapse of Lehman Brothers, but they won’t lend it out to firms and households.  No wonder Bernanke is preparing the ground for another $1 trillion of quantitative easing.

Bank lending to US small business that is not backed by property (non-mortgage lending) has fallen 28% since the end of 2008.  Bank lending to large firms has also fallen substantially in the GFC, but they have more than made up for it with extra borrowing in the corporate bond market.  It is small businesses in the US that are experiencing a rapidly shrinking supply of bank credit.  The picture is no better for lending by finance companies which has fallen 12% since late 2008 and continues to fall quarter by quarter.

Its hard to know when monetary policy will become efficacious again in the US.  For two years now the Fed has had no ability to influence bank credit creation through interest rate changes.  That is such a long time that the failure of monetary policy seems normal now.  It will be a happy day when bank credit starts to grow again in the US.

2 Responses to "US banking system still badly broken"
  1. Bank lending is based on finding people with assets they are willing to mortgage.  Bank lending is not based on finding people who are willing to create new assets and new value. That is, bank credit is about buying old assets not creating new assets.  New assets are financed from savings not credit. Finance from savings is more expensive than finance from credit.
    The way to change – and fix the system – is to change the incentives so that it becomes less expensive to finance the creation of new profitable assets than it is to buy the equivalent existing assets.

  2. Agreed, flow of funds is extremely interesting. However, the contraction in bank credit may be due more to demand factors rather than supply, meaning quantitative easing isn’t the best prescription.
    The senior loan officer survey shows falling loan demand, falling interest rates and easing credit standards, generally speaking. However, that being said, there are many good arguments supporting/ rubbishing the idea that the contraction in bank credit is due to lenders tightening credit standards rather than falling loan demand.

%d bloggers like this: