The Hidden Secret of the US Banking System

June 28 2017

Despite disappointing US economic growth in the first quarter of 2017, the Federal Reserve has, generally speaking, been quite positive about the economic recovery and that opinion is as a general rule shared by press reporters and investors. It has been sunshine and roses in the Fed´s wonderland. And it seems as if they are right. Seems, because in my quest to find out what is happening below the surface, I came across a curious development. One of those facts that would raise some eyebrows. Is this the hidden secret of major US banking institutions? And what is the explanation behind this recent development?

What Secret?

We saw in one of my previous articles that the number of corporate loans is darn cyclical. Both for commercial and industrial loans, the general rule is that banks extend these loans in a metaphorical high season. As soon as the bottom falls out, and the number of corporate loans that are pushed into default goes through the roof, it is almost as if banks are pulling the plug on corporate credit extension. Corporate loans by the banking system have by their very nature an important cyclical component. Thus far, I have stated the obvious.

Now the little bit less obvious: banks often require collateral for corporate loans. Better said, a bank, in a majority of cases, does not simply lend money without any tangible guarantees. If there is some kind of collateral, then collateral is preferred. Business property, machines, equipment, trucks, etc. If not, banks diligently examine the net cash flows of a corporate business. The idea is, of course, that whenever the underlying business gets into serious trouble and is unable to repay the loan, the bank can simply claim the collateral, sell it, and recover or limit its losses.

How many of all outstanding corporate loans, on the books of an US-based bank, is backed by collateral?

That was, as a general rule, somewhere from forty to fifty percent of all outstanding corporate loans.

Gradually, US banks have upped this percentage significantly over the past two years. To a level of about 75% of the value of all outstanding corporate loans. Observe the following chart:

Source: St Louis Fed

What could bet he reason that banks went from less than forty percent of all corporate loans backed by collateral at the end of the 90s to over seventy-five percent of all corporate loans in the past few months?

Could this be a sign of impending trouble?

I suspect it is. My thesis is that banks are watching interest rate rise gradually (the net interest rate margin of banks is, by the way, also at a historical low) and they know that whatever is coming will not be pretty. They prefer to be rather safe than sorry. That is why they are limiting extending corporate loans with collateral, or even in some of the cases require additional collateral for existing loans. The banks know something we seem to miss. The banks know something that we are unable to infer from apparent positive macro-economic aggregates. The banks, with their day-to-day observations derived from practice rather than macro-economic aggregates, are beginning to tighten the reins.

And this image is confirmed by numbers from the US auto industry and overall growth in bank credit, which has slowed down considerably. But more about that later. 

The Average Maturity of a Corporate Loan Was Never This High

Not only the facts discussed above are extremely revealing. What is also very revealing, is the fact that the average maturity of a corporate loan has increased considerably in recent years. Better yet, the average (weighted) maturity of a corporate loan was never as long as today.

The average (weighted) maturity currently reached a level of almost 750 days (about 25 months). In 2010, the average maturity was “only” 375 days, exactly the half. And in 1998, average maturity was only 270 days, or nine months. Fast forward twenty years, and banks are lending to corporate businesses three times as long as before. Also observe the following chart:

Source: St Louis Fed

A mere coincidence? Not quite. The role of the “almighty” Federal Reserve is utterly clear. Only with the help of the Fed (and the US Treasury) that they provided to the banking system, banks can allow themselves to lend money at increasingly longer maturities. In the past, this was not possible, because a bank would begin to lose liquidity in a heartbeat. Nowadays, liquidity is no longer a problem, as you can also read in my article from last week.

A Recipe for Trouble

In brief, US banks are beginning to ask for more guarantees from corporate businesses and have increasingly been backing their corporate loans with collateral. And all this after those very same banks have been extending corporate loans, over the past few years, at increasingly longer (and therefore increasingly risky) maturities. But longer maturities mean higher risk, especially in an environment of rising interest rates. This pyramid scheme will end prematurely when businesses are no longer able to refinance their debts. That is just trouble looking for a place to happen.

Last week, I examined a bank balance sheet from a Scottish bank in one of the most successful periods of “free banking” (a banking sector with little to none government intervention). What would you think I would observe? This Scottish bank had almost no assets with long maturities. The assets consisted mostly of short-term commercial credit. Such are the incentives of a bank in a banking system in which it cannot rely on the unconditional support of a central bank and a generous government.

The fact that banks are currently anticipating a new crisis, by requiring corporate loans increasing amounts of collateral, is a sign of what we can expect down the road. A subset of banks will not be able to withstand a new crisis, in the midst of a financial sector and economy that is completely illiquid. That additional collateral will, when things get ugly, not make a decisive difference for the most illiquid among banks.

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