The Dow Jones Industrial Average (^DJI 0.40%) was down about 23 points as of 1:05 p.m. EDT Wednesday.
The blue-chip index has rocketed higher over the past few years at breakneck speeds. Many pundits today question just how much longer this streak can continue. But the market is not homogeneous, and to really assess the condition of this bull run, we need to assess the fundamentals of the industries just below the surface.
Today we will do just that for the financial industry. The key to that assessment is the nearly $2 trillion in cash sitting on bank balance sheets.
An industry in transformation
We all know that banks were a major driver of both the financial crisis and subsequent Great Depression. We also know that the regulatory environment has shifted dramatically in response. This set in motion a transformation in the industry.
That growth was primarily driven by an increase in loans -- a welcome sign of banks getting back to doing what they do best: lending money. Foreclosed properties are also down, further reflecting an industry on the mend.
The main hindrance on growth in assets has been a decline in trading assets, an effect of new regulations such as the Volcker Rule.
Source: BankRegData.com.
A trend that's harder to explain -- the piles of cash at big banks
What's harder to explain is why banks today are holding a $1.8 trillion cash hoard on their balance sheets.
This is cash that could be put to use in new loans, in securities, or a whole host of other areas. Instead, the cash pile grows, businesses and consumers don't have access to that capital, and bank investors scratch their heads over assets with essentially no yield.
Looking at the data relative to a bank's total asset size offers a better understanding of exactly what's happening. The chart below breaks it down as of the first quarter of 2014.
This chart compares the ratio of net loans to total cash at banks segmented by their total asset size. What the chart tells us is that the largest banks and the smallest banks are hoarding cash on a relative basis. For example, the four largest U.S. banks are holding $3.08 of loans for every $1 of cash on their books.
Source: BankRegData.com.
The sweet spot for putting the cash to work appears to be banks with more than $250 million in total assets (your typical community bank) and less than $50 billion in total assets (mostly regional banks with a presence in just a few states).
We can also eliminate blame on the smallest of banks even though their ratio of loans to cash is on par with the megabanks.
On an absolute scale, the four largest U.S. banks -- JPMorgan Chase (JPM 0.06%), Bank of America (BAC -0.21%), Citigroup (C 1.41%), and Wells Fargo (WFC -0.03%) -- hold over 50% of the entire industry's cash balance.
So why are the megabanks holding all this cash?
There are a few reasons that could be driving banks to hold such a ridiculously high cash balance.
1. Regulatory changes
As the new Basel III capital requirements continue to be phased in, banks are being forced to recalibrate their balance sheets to comply. That means moving some riskier assets out of the business or stocking up on risk-free assets to compensate for riskier investments.
Furthermore, as banks wind down their now-illegal proprietary trading desks, the capital that would have been deployed into that division could be sitting in cash. This would also help explain why the impact is so much more pronounced at large banks -- smaller regional and community banks simply didn't ever have trading desks.
2. Loan demand
As a nation, individuals were significantly overleveraged heading into the financial crisis. So much so that the deleveraging process is still working its way through the economy.
Individuals and businesses are, in general, not interested in borrowing money at the same volume as in past recoveries. This is in spite of the record low interest rates available for all types of loans.
When prices (in this case, interest rates) are this low and loan volume is still struggling to increase, it's fair to blame poor demand for the cash sitting on the books.
3. The Fed
Historically, banks have invested in securities to increase asset yields instead of letting that capital sit as cash. Today, though, yields are exceptionally low across the board as a result of the Federal Reserves near-zero interest rate policy.
Banks, particularly large institutions, could view the risk/reward equation differently today because there is so little yield to be gained by investing the cash into securities.
I believe this is the most likely primary driver behind the megabanks' cash pile. The alternatives are simply not appealing enough.
What does this mean for the future?
I see this trend as a positive for the long-term prospects in banking. Loan growth is returning, capital levels are increasing, and the most risky bank practices have at least been subdued.
The Federal Reserve's near-zero rate policy will end soon enough -- the central bank is already scaling back its quantitative easing programs.
When that happens, the industry will have a massive amount of dry powder in the form of cash balances to put to use.
But just like we need to look at specific industries to assess the health of the overall market, we also must look at specific companies to understand their industry.
Jamie Dimon, CEO of JPMorgan Chase, said in the bank's earnings call that "not all companies are created equal." By that he meant that some banks will find ways to maximize their yield, adapt to new regulations, and flourish in today's redefined banking environment. On the other hand, others will not.
So even as the industry improves overall -- foreclosures are down, loan growth is returning, highly risky trading assets are on the decline -- the specific performance of individual companies will dictate the future for the industry in the market.
