My concerns about the rate of growth in bank originated and serviced commercial and industrial loans (C&I) have mostly centered on the lack of productive enterprise that drives economic activity and job creation, which come from the proceeds of these loans by the corporate borrowers. Those concerns are about to become much more complex as they are poised to become the largest asset class in the U.S. banking system by the end of this year.
This is an extraordinary event. Ever since the creation of the Federal Housing Administration (FHA) as part of the National Housing Act of 1934 (from which the government created the Federal National Mortgage Association in 1938 to promote home ownership and the mortgages required), the largest single asset class in the U.S. banking system has been first trust residential mortgages, by far.
This indicates a profound structural change, not only in the U.S. banking system but also in the economy itself. Although few are aware of this issue, as C&I loans become the largest asset class in the banks, the financial media will increasingly write about the subject. It will become a political issue and require the attention of legislators and regulators.
Since the failure of Lehman Brothers, the dominant conventional wisdom within the private financial sector, economic academia, the executive and legislative branches of the U.S. government, the Federal Reserve, and the various other financial regulatory bodies, has been that the effects of the Great Recession, although large and lasting, are temporary or cyclical, not permanent or structural. Expectations are that the U.S. economy would eventually recover and resume the traditional pattern of a consumer-led expansion that would lead to production and job increases.
That assumption is now being questioned. As C&I loans become the largest asset class in the banks, many more regulators and legislators will be compelled to discuss the potential for the U.S. to experience the greatest shift in its fundamental structure since the era of New Deal legislation of the 1930s.
The economy, financial institutions, the capital markets, and the legislative and regulatory interaction with the private sector were founded on the traditional belief that expansions and contractions in economic activity begin with retail consumers. That's the front end of everything.
When consumers are lacking in confidence, consumption declines, economic activity decreases, monetary and perhaps fiscal counter-cyclical responses, are put on in the belief that they will be temporary until consumers regain their confidence and increase consumption again. This has not been the case for the past five years. The dominant belief continues to be that eventually the consumers' confidence will recover.
U.S. Federal Reserve Board Vice Chairman Stanley Fischer raised the issue that this may not be the case this time in a speech he gave in Stockholm, Sweden yesterday. In "The Great Recession: Moving Ahead," he addressed this precise issue and used the term structural eight times.
I strongly encourage everyone to read it because the speech was not just about the U.S. or other sovereigns, or even the global economy, but about the totality of economic events that have occurred since the Great Recession all around the world. He also focused on the potential for some of them to be indicative of structural, permanent changes in the way economies operate. These will require legislative, regulatory attention and perhaps changes to the macroprudential regulatory framework and the application of monetary and fiscal policies.
Of most immediate importance to traders, speculators, investors, as well as the prospects for the capital markets, is that the Vice Chairman of the U.S. Federal Reserve Board just admitted that the way the economy is functioning, and has been since the Great Recession, does not comport with what should be occurring according to established economic models.
From a broad perspective though, the performance of the capital markets seems to be reflecting the belief, with assurance from monetary and fiscal policy makers, that no structural changes have occurred and that the economy is recovering as expected.