Financial Liquidity & Banking System

Liquidity
There has been little change in my broad credit-driven measure of
financial liquidity in months. On balance, private sector credit
demand has remained lax, so banks have done little to create or
compete for the deposits that would touch off faster broad liquidity
growth. Interestingly, the Fed did ease along with monetary
liquidity in June, which it will need to continue to do if private sector
credit demand does not recover. The Fed is looking at its options in
this regard.

The Fed's outreach programs show that some bankers are reluctant
to lend to smaller businesses with strong cash flows because of
concern over collateral values and is indicating to banks that healthy
debt service capability should receive more priority. It is also clear
that even though FICO credit scores for households have slipped only
slightly over the past two years, banks are employing more stringent
standards in extending consumer credit. So, even though credit
demand has been modest in this economic recovery to date, it is
becoming more clear that bankers are also maintaining conservative
practices adopted in the immediate wake of the financial crisis. This is
a natural development given the grand magnitude of loan losses the
banks have piled up over the past two years, but at some point
before too long, they are going need to loosen up a little, especially
with regard to business credit.

Banking System
As is typical of recession / post recession periods, the banks have
been letting the total system loan / lease book run off. On a revised
basis the run off has been roughly $600 bil. or 6.2%. Even so, the
L&L book remains about $400 bil. over the long term trend as the
banks bring the book slowly into line with trend. By the same token,
banks have substantially increased their investment portfolios, and
my flash liquidity indicator (Treasuries vs. shorter term business
loans) has shown marked improvement. Bank capital has been
growing, and loan loss reserves have recently shown more stability.
It was also good to see that both consumer loans and commercial &
industrial loans showed stability in June, after lengthy declines. The
banks have a considerable way to go to get back into long term
balance, but there has been enough improvement to enable them to
participate in the economic recovery in a moderate way.