Do Banks Need Another Quantitative Easing or Some Quality Improvements?
Jay is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
So the Federal Reserve has been entertaining the idea of making more credit available to the U.S. economy, which by all means is in a very slow recovery. Two earlier rounds of so-called quantitative easing by the Fed after the financial crisis have already given banks more capital at their disposal to stimulate the economy. But how willingly banks are lending out their extra capital is a real concern, as some question if banks have become too conservative with their lending practice. There is also the issue of credit demand from businesses and consumers, considering that excessive borrowing and subsequent defaults were what caused the recession in the first place.
If banks are overly cautious with their lending, businesses reluctant to invest and consumers unwilling to spend, allocating to banks yet even more capital via another quantitative easing doesn’t really address the root cause of the slow economic recovery. To really benefit the economy, banks ought to focus on improving the quality of their lending operations with the capital they have. Acting on the tendency of avoiding risks at all costs, banks may miss out certain credit-worthy borrowers and won’t be able to carry out as many quality loans as they potentially can. Holding capital without effectively using it may at the end lower a bank’s overall financial performance, something that bank investors should be aware of, especially in today’s quantitative-easing environment.
Many large U.S. banks such as Citigroup (NYSE: C) and JPMorgan (NYSE: JPM) have their securities divisions acting as so-called primary dealers - trading partners of the Fed. Federal monetary and banking regulations require that a primary dealer participate in Treasuries auctions and trade government securities with the Fed for the purpose of influencing money supply as desired and prescribed by the Fed. A typical quantitative easing means that the Fed buys Treasuries from banks of primary dealers, freeing some of the bank capital tied to Treasuries holdings to allow increased lending uses. The additional capital on hand, however, doesn’t necessarily trickle down to the economy if a bank has chosen to sit on the extra cash or turn around to purchase more Treasuries for safety.
It’s up to individual banks to decide whether to make less predictable loans or hold safer securities. In 2011, the amount of securities holdings at Citigroup is almost half the total value of its outstanding loans. At JPMorgan, the securities-over-loans ratio is over 70 percent during the same period. Meanwhile, returns on securities investments and loans are 2.8 percent vs. 7.8 percent for Citigroup and 1.8 percent vs. 5 percent for JPMorgan. As a result, the two banks were making less money by hoarding capital in securities and shunning lending. Of course, banks with extra reserves can always safely lend to other banks that are falling short of required overnight reserve with the Fed due to their increased lending activities. But with the federal funds rate at near zero percent, earnings from overnight lending for banks with extra capital are minimal at best.
Non-primary-dealer banks, especially smaller regional banks, that are not directly involved in a quantitative-easing operation rely on federal funds borrowing for additional reserve capital to back up any expanded banking operations. In other words, as banks increase their business and consumer lending activities, reserves kept at the Fed must grow accordingly based on the Fed’s reserve requirements. So the lower the federal funds rate is, the more likely these banks will take on additional lending because of cheaper reserve financing costs. This has helped regional banks like U.S. Bancorp (NYSE: USB) and PNC Financial Services (NYSE: PNC) expand their lending activities, creating more accommodating credit market conditions for their customers. The dollar percentage of securities holdings over outstanding loans for the two regional banks was both within the 30 percent range during 2011, a sizable decline compared to those for big banks. With less capital tied up to securities and more devoted to lending, these banks rewarded their investors with better returns on capital, as well as higher stock prices. Currently, U.S. Bancorp stock has a price-to-book ratio of 1.8 and shares of PNC Financial are only 5 percent below book value, while many big banks are trading significantly below their stated book value.
The talk of quantitative easing certainly is more of a concern for the Federal Reserve. But for bank investors, it’s not about how much more capital banks may have; it’s more about how banks can better use the amount of capital on hand. Quantitative easing may put more pressure on large banks to find lending opportunities, as they often are more prone to financial securities investing. Meanwhile smaller banks can really take advantage of the ample credit supply with their natural focus on basic banking operations.
JJtheArdent has no positions in the stocks mentioned above. The Motley Fool owns shares of Citigroup Inc , JPMorgan Chase & Co., and PNC Financial Services. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.