Financial System Liquidity

We are now nearly 18 months into a US economic recovery, and the loan book of the banknig
system continues to contract. By post WW2 standards, this is a truly extraordinary story,
although it is an understandable one given the depth and duration of the preceding recession.
At its peak in Half 2 '08, the system's loan book was about $1.5 tril. or 8.2% over the long term
growth trend. It is now only $220 bil. or 3% above the long term trend. The system is still
carrying loan loss reserves in excess of $200 bil., and there has been but modest improvement
in the ratio of nonperforming loans to total loans. There is ample liquidity on the system's
balance sheet and lending standards are starting to be relaxed. However, the banks are behaving
with great caution.

Consequently, the boad measure of system liquidity to include the basic money supply and
primary funding tools has incresed only slightly from it's recession trough and remains a bit
below the historic peak seen in late 2008. This is true despite the very large injections of
liquidity by the Fed ($1.5 tril.) to stabilize and grow the system since latter 2008.

From my perspective, the recovery has primarily been a "cash and carry" affair, with the
Fed's large liquidity infusions being the lifeline for the recovery.

With system cash and checkables accounting for only 16% of the broad measure of cash plus
the broader array of deposits and funding vehicles like commercial paper, the burden on the
Fed to supply supporting liquidity is enormous.

We are very much in the kind of situation the Fed and the economy faced in the years
after the Great Depression trough, when private sector credit availability was contracting.
Then as now, there is pent up demand for goods and services, but the very narrow base
of liquidity expansion reduces the visibility of growth nonetheless, and, with the Fed serving
as the main game in town, confidence stays restrained.

The consumer has begun to loosen up and spend more here in the closing months of 2010,
and now time is at hand for business and the banks to respond more positively with jobs,
investment and credit.