US Banking System -- Long Term

Over the 2004-08 period, bank loans/leases expanded rapidly,
running up from $4.4 tril. to over $7 tril. This ballooning of loan
exposure is far more rapid than a sensible growth trend would
indicate, and it has left the banks vulnerable to continued large
loan losses in a weak economy. Lest they be fairly accused of
hiding earnings and dividend payout from shareholders, banks
cannot book higher loan loss reserves for the hell of it. Moreover
since senior executive compensation is based on earnings
progress, there is a reluctance among bank execs to bolster
reserves until evidence they should becomes more compelling.
Even if you are an insider with a large loan book right under your
nose, it is not so easy as you might think to accurately discern
what may go bad in the year ahead.

Because loans rose so far above a sensible trend over 2004-08, I
think it is fair to say quality standards were quite relaxed and
that there could be up to $1.5 tril. in loans that could go bad if
the economy stays so weak. Losses of such a staggering
magnitude would wipe out bank equity capital and leave the
system insolvent. I know I do not know whether the banks could
wind up with a loss of such a magnitude, but it seems plain that
vulnerability to further substantial losses seems likely enough.

If the Obama team and bank regulators deem it necessary to
secure bank capital, some sort of consolidated standby facility
would seem most appropriate as the risks of abuse are large
if banks are allowed to dump loans ahead of the normal loan
loss accrual process. By the same token, regulators would likely
be best served by securing authority to force merge or shut
down the basket cases.

Now, the US economy can expand for a good 12-18 months
without recourse to heavy loan growth as recovering business
cash flows normally can meet recovering working capital needs.
Similarly, the residential market is so depressed, that early
stage recovery will not strain the mortgage market. Thus,
when the economy stabilizes and begins to move forward, there
will be substantial time to assess more fairly the banking system's
exposure to the credit "bubble" of 2004-2008. This is more
fodder for the standby facility case.

There is great concern now about the soundness of the banking
system, but the more pressing issue is stabilization of the
economy and asset values and that is where the primary
policy focus should be.