Watch Out: Small And Midsized Banks Need Watching

Janet Yellen, U.S. Treasury Secretary, suggests that there will be more bank mergers coming up in the future.

With interest rates at higher levels and going higher and with some bank closures on the books in 2023, small and midsize banks experienced depositors flying away to larger banks that depositors believed were less likely to fail.

The only way to fight this drain...pay higher deposit rates.

And, now these small and midsize banks are suffering smaller profits.

But, these small and midsize banks are facing liquidity problems with the loss of cash.

The probability that many of these small and midsize banks might seek to be acquired has risen and will rise during the year.

Wait a minute.

I just posted an article that discussed all the "cash" that was hanging around the banking system.

The latest total was around $3.3 trillion of cash assets resting in the commercial banking system.

But, who is holding all these cash balances?

A look at the latest data from the commercial banking system (coming from the Fed's H.8 statistical release, Commercial Bank Assets and Liabilities) there is a massive difference in who is holding the cash.

For example, of the $3.3 trillion is cash assets in the commercial banking system, small, domestically chartered banks hold only $466.9 billion in cash assets.

The ratio of cash assets in these small banks represents only 7.2 percent of their total assets.

How does this number compare with the cash holdings of the large, domestically chartered banks in the country?

Note: there are only 25 commercial banks in this class.

Well, the 25 largest domestically chartered banks hold $1,574.0 billion in cash assets, which represent 11.8 percent of the total assets of these banks.

In order to put this further into perspective, however, we need to note that the 25 largest domestically chartered banks in the United States have $13.3 trillion in total assets while the rest of the domestically chartered banks in the U.S. possess about $6.6 trillion.

The rest of the U.S. banking system?

Well, foreign-related commercial banks have $3.0 trillion in total assets.

Foreign-related commercial banks also possess $1.3 trillion in cash assets, which represent 42.7 percent of their total assets.

So, most of the cash assets held by commercial banks in the United States are owned by the largest banks! The small and midsized banks are not near as loaded with cash as the larger ones and the small and midsized ones do not have near the cash cushion as do the larger banks.

To put these numbers into perspective let's take a look back to before the recent Covid-19 pandemic storm.

On December 28, 2019, the small and midsized banks held 5.9 percent of their total assets in cash assets.

On the same date, the largest 25 domestically chartered banks held 8.1 percent of their total assets in cash assets. For foreign-related banks, the number was 28.5 percent.

Going back to the end of 2000, on December 27, 2000, the ratios were as follows: the largest 25 banks held 5.5 percent of their total assets in cash; the small banks held 3.8 percent; and the foreign-related banks held 6.1 percent.

This time can be considered a "more normal" time for the banking system and the holding of cash reserves.

But, what has happened recently?

Growth of Cash Assets

Let's look at the movement in cash assets in the banking system over the past five years.

Growth of Cash Assets (year over year)

2018 --19.4 percent

2019 -- 12.8 percent

2020 + 77.9 percent

2021 + 33. 9 percent

2022 -- 23.2 percent

2023 (first quarter) + 4.1 percent

2023 (April) +9.5 percent

2023 (May) + 10.0 percent.

Analysis

Jerome Powell took over the helm of the Federal Reserve on February 5, 2018. During the time Janet Yellen was chair of the Fed, the economy was growing, although slower than some would have liked.

Before Yellen, the economy had gone through three rounds of quantitative easing, and financial markets were thought to have plenty of liquidity.

Mr. Powell needed to do little when he became the chair.

Given a pretty confident world, the commercial banks allowed their cash assets to go down.

In 2020 the scene changed, the Pandemic hit, and Mr. Powell and the Fed pumped trillions of dollars into the banking system. This was the fourth round of quantitative easing.

As can be seen, cash assets in the banking system rose by almost 80 percent during that first year and then rose by another third in 2021.

This was the period of the asset bubble created by the Federal Reserve.

But, as can be seen in the material presented in the earlier part of this post, the largest 25 commercial banks in the U.S. substantially increased the percentage of total assets they held in cash. They went from 8.1 percent at the end of 2019 to over 11.0 percent in the spring of 2023.

The small banks went from 6.0 percent at the end of 2019 to over 6.5 percent in the spring of 2022.

The foreign-related went from 28.5 percent at the earlier date to over 40.0 percent in the spring of 2023.

In other words, during the swings in monetary policy during the period of the pandemic, the cash assets at commercial banks rose dramatically.

And, most of the cash assets that were captured went to the 25 largest domestically charted commercial banks in the U.S. and to the foreign-related banks in the U.S.

In other words, there has been a tremendous shift in liquidity in the commercial banking system over the past year or so.

And, one could argue that the largest banks in the U.S. have moved to protect themselves from the swings and turmoil of a troubled banking system while the small and midsized banks have not been able to add much protection to their position.

Conclusion: small and midsized banks are much more exposed to bank troubles than they were not too long ago.

Conclusion: more bank mergers coming up in the near future.

This will be especially true if the Federal Reserve really maintains a policy aimed at defeating inflation.

Investors need to be aware of this buildup in the commercial banking sector of the economy.