Business Insider

Peter Crabb: A return to normal banking could lead us out of the credit crisis

Spring is popping up everywhere. Green shoots are even showing up in the banking industry.

In a widely watched interview on CBS’s 60 minutes last month, Federal Reserve Chairman Ben Bernanke said he saw some positive signs in the financial markets suggesting that the pace of economic decline is slowing and that there are reasons to optimistic for a recovery later this year.

However, the economy remains mired in a credit crisis. Banks continue to hoard cash, holding more reserves than required by regulators and not lending much. Until the banks get back to normal operations, any upturn in the economy is likely to be weak.

In normal times, when the Federal Reserve policymakers want banks to lend more, the Fed goes out and buys Treasury bills, thereby lowering interest rates to encourage lending. In this recession, the Fed has done all it can on this front.

But in a credit crunch like this, banks and investors still leave their money is cash (currency, coin, etc.) or short-term Treasury bills. Excess reserves at U.S. banks are currently over $770 billion, more than 250 times what they were just one year ago. They remain near their high of $798 billion reached in January.

The Fed has tried to sidestep this problem by going around the banks. Policymakers have developed many new programs to lend directly to the public and to businesses, including auto part suppliers and insurance companies.

What have the banks been doing while sitting on so much cash this long?

It turns out they are getting back to more regular banking activities and less speculation in mortgage and other markets.

Greg Farrell and Michael Mackenzie of the Financial Times report this week that large banks are reporting good first-quarter revenues by conducting “the old-fashioned business of trading for clients in the capital markets.” Banks are spending less time trading securities like stocks and bonds for their accounts and instead engaging in the old, “boring” business of working as brokers for investors.

Traditionally, major U.S. banks have operated as market makers for investors by buying and selling bonds, currencies and many other financial securities. The profit on this tried-and-true service has improved as firms have consolidated or left the industry.

A market maker is any firm that quotes both a buy and a sell price for a financial security, making a profit on the difference in these prices. This bid-ask spread for securities is a common measure of the liquidity of the market.

The spread was very large during the crisis of last fall, leading to little volume and therefore little profit for the banks. Since then, spreads have narrowed and the resulting increase in activity has given banks more to smile about.

The uptick in revenue from this business will serve to improve bank profitability this year and potentially lift us out the credit crisis. Regulators and policymakers should support a return to normal banking operations for the major banks.

Idaho Attorney General Lawrence Wasden correctly notes in a Reader's View in the opinion pages of Wednesday's Idaho Statesman that that national bank regulators were lax in their oversight of these large financial institutions. He called for stronger support of our state's and other states’ rights to enforce banking rules and joined a request to the U.S. Supreme Court to hear a case on the subject. If successful, that would go a long way toward improving bank operations.

Such actions will lead to improvement in lending practices at local banks, and large money-center banks can get back to their profitable business operations of the past – serving their investor clients.

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.