This is my monthly report on bank lending. Last month I reported on the continued absence of the commercial banking industry in loan markets. (See my post of September 10, 2009, “Bank Lending Stays on the Sidelines”: Bank lending was still absent during the most recent month, but there now seems to be a significant shift in the commercial banking industry: greater changes seem to be taking place in the smaller banks than we have seen during the current economic crisis.

This deterioration in the industry figures coincides with the increasing number of failures that are registering with the Federal Deposit Insurance Corp. (FDIC). This problem made the front page of the New York Times on Sunday: see “Failures of Small Banks Grow, Straining F. D. I. C.”, And, with more than 400 banks, almost all of them small ones, on the FDICs list of problem banks, we can expect the number of failures to grow and the bank lending figures to continue to shrink.

Total assets at commercial banks declined by $320 billion over the latest 13-week period according to the Federal Reserve. Of this total, the decline in assets over the last 5-week period was $250 billion indicating that the slide at commercial banks is not receding. Although the absolute decline in both periods of time was greater for the large banks, the percentage change was greater for the smaller banks.

What is most interesting is that the absolute decline in bank loans and leases in both periods was roughly the same for the large banks and the small banks. The decline in loans and leases over the 13-week period was $112 billion for large banks: $97 billion for small banks. However, for the last 5-week period the decline in this figure for small banks was $69 billion and $66 billion for large banks.

Commercial and Industrial loans, business loans, continued to drop at a rapid pace over the 13-week time span ($108 billion) as well as in the 5-week period ($50 billion). Relatively speaking the declines were equally divided between the large banks and the smaller banks.

The big difference between the different size banks comes in the area of real estate loans. Overall, real estate loans dropped by $113 billion over the last quarter, $48 billion over the last 5 weeks. But the decline in small banks was $68 billion for the last quarter and $38 billion over the last 5 weeks. The figures for large banks were $41 billion and $6.3 billion, respectively.

Here we find the startling difference: the small banks experienced most of the drop in real estate loans in commercial real estate loans. The drop in commercial real estate loans at small commercial banks was $36 billion for the full 13 weeks, but most of the decline came in the last 5-week period as these loans dropped by $24 billion during this latter time.

We have been hearing for months that there was going to be a problem in commercial real estate lending and that this problem was going to be centered in regional and local commercial banks. It looks as if this problem is finally hitting the banking system and is showing up in the numbers. This is an area that we are going to have to continue to watch for the economic difficulties in commercial real estate could continue to paralyze the smaller commercial banks for quite some time going forward. And, with the large number of problem banks identified by the FDIC being smaller institutions, we could see a rapid increase in the number of these institutions going under.

It should be noted that commercial real estate loans at large commercial banks actually increased over the past 13-week period and roughly held constant for the last five.

Another sign that these difficulties are piling up at the smaller commercial banks is the accumulation of cash assets at the smaller institutions and the timing of this build up. Cash assets at small commercial banks rose by $54 billion over the past 13 weeks. These assets increased by $48 billion over the last 5 weeks. That is, most of the increase in cash assets came at the time that time that the commercial real estate portfolio at these banks were declining the most.

The implication of this behavior is that the smaller banks are really starting to suffer and this is leading them to take a more-and-more conservative position in their balance sheets.

It should be noted that large commercial banks actually reduced their holdings of cash assets during this period. The decline over the 13-week period was about $5 billion, while over the last 5 weeks the decline was a whopping $70 billion. So, large banks build up their cash position over the first 8 weeks of the period and then reduced this position substantially over the last five.

The basic conclusion that can be drawn from this analysis is that the balance sheets of the commercial banking sector continue to shrink and with this shrinkage we see very little new borrowing taking place.

The big story this month is that the smaller banks in the country are really being hit with problems relating to bad assets. As a consequence, their balance sheets are suffering much more than their bigger counterparts and this is especially true when it comes to commercial real estate. Not only are the smaller banks reducing their exposure to commercial real estate loans, it appears as if this retraction from the lending markets is connected with an overall move by these banks to much more conservative lending practices.

Such a move would certainly not contribute to economic recovery, especially on Main Street. It is true that the larger banks are also contracting their balance sheets now, but they will tend to be the first ones to get back into lending when the time is right.

However, if the smaller banks change their “risk preferences” and become more “risk averse” during this period of restructuring it is highly unlikely that we will see them return anytime soon to contribute to an economic recovery in their geographic area. Since these organizations do not have the same access to resources as their larger counterparts, they will probably stay very conservative for an extended period of time.

Just one thing more. Last week Excess Reserves in the banking system reached an all-time high. For the two week period ending October 10, Excess Reserves averaged $918 billion! This, of course, is being allowed to happen by the Federal Reserve System as reserve balances at the Federal Reserve got close to the astronomical figure of $1.0 trillion! This figure only averaged $960 billion in the banking week ending October 7, but daily figures over the past two weeks did reach levels substantially higher.

The banking system is weak. It remains weak. Maybe some of the larger banks, the ones that got bailed out, are doing OK. This does not seem to be the case for the smaller banks. The FDIC knows this. The Federal Reserve knows this. It is not a comfortable situation!