Banks Are Going to Cash

 | Aug 14, 2013 | 6:00 PM EDT
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An odd series of events are unfolding in the banking system. As the banks slowly but steadily clean up legacy balance sheet issues (mostly attributable to non-performing mortgages), they counter-intuitively become more cautious and conservative managing their assets.

I don't know why this is happening but it is obvious in their financial statements. The Federal Reserve's monetary support over the past five years was supposed to supply the banks with the liquid capital necessary to afford for the losses that need to be absorbed. During that process, like an injured person convalescing, it was expected that the banks would be more cautious on lending. It was logical, and that is indeed what happened.

I've discussed many times in the past few years that the only category of loans experiencing an increase across the banking sector has been Commercial & Industrial loans (C&I). These are loans made by institutions to their most creditworthy commercial borrowers. Every other loan class either stagnated or declined as banks tightened underwriting criteria.

It's been expected. Economists have been anticipating that once bank balance sheets were showing signs of repair and a trajectory for that to continue, the banks' animal spirits would reassert themselves and, in the process, become more aggressive about making loans and managing assets.

But this is not happening. Although the total value of loans outstanding has slowly risen, this is almost totally attributable to the increase in C&I loans. Even more interesting, perhaps ominous, is what banks are doing with their other assets. Not only have total assets declined each of the past two quarters, but also cash balances have risen to 10-year highs and now account for 10.7% of total bank assets. The amount of money in cash accounts (both interest and non-interest bearing) has slowly but steadily risen since Lehman Brothers failed.

It's also interesting to note that the money centers with the least expensive and direct access to capital from the Federal Reserve are the ones holding the largest percentage of their own assets in cash today. As is the case with individuals, cash is not a place one holds capital expecting a positive return. It's a defensive position and is typically put on in anticipation of negative returns in the near future for other asset classes -- stocks, bonds, commodities, currencies and real estate.

This is most pronounced at JPMorgan Chase (JPM), where the value of cash balances has surged in the past two quarters to $305 billion at the end of the first quarter of this year from $177 billion at the end of last year, and $345 billion at the end of the second quarter this year. Those are huge increases, going from about 9% of assets to about 17%.

At Citigroup (C), the increase has been to $170 billion from about $122 billion. But the $170 billion is closer to a long-term figure and $122 billion is a dip. At Wells Fargo (WFC), the increase has been slow and steady over the past four years, but it has also turned up a bit in the past few quarters, moving to $137 billion from about $128 billion. Bank of America (BAC) is the only one of the money centers that experienced a decline, with cash assets shrinking to $130 billion from $165 billion. That's not because they are shifting into other assets, though, or making more loans. They are just spending cash on loss absorption and lawsuit settlements.

There has also been a decline in the value of securities held and the value of assets held in trading accounts by the money centers. Again, the biggest shift has been by JPMorgan, with the value of securities held declining to $333 billion in the second quarter from about $354 billion in the first. During the same period, the value of its trading account decreased to $271 billion from $302 billion.

Not only are the banks becoming more risk averse, but also the largest are becoming the most risk averse, with JPMorgan, typically the most aggressive, taking the largest steps away from risk in the last 90 days. JPMorgan's trading account is now at its lowest value level and percentage of assets since Lehman failed. Its outsized moves may partially reflect the recent political heat it's been receiving concerning past trading errors, but it may also reflect increased expectations of a negative correction in the securities markets soon.

The conundrum is why the banks collectively are becoming more risk averse while their balance sheets are repaired. I don't know the answer, but it's another issue for investors to be aware of.

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