Why the American recovery is so slow

Even though it's been nearly five years since the onset of the financial crisis, the economy continues to suffer from its effects. GDP growth remains lacklustre and unemployment seems to have stalled above 8%, nearly twice the so-called natural rate.

With the election campaign season in full swing, it's easy to blame politics. Democrats are likely to pin it on the Republicans for their refusal to underwrite fiscal stimulus akin to the New Deal. Republicans, meanwhile, probably think the stunted recovery has more to do with big government and overburdensome regulation.

In reality, however, if you were to isolate only one group, the responsibility lies most on the banks, gatekeepers of the nation's credit. The purpose of the banking industry is simple: to accept money from depositors like you and me, and reallocate it to businesses and entrepreneurs who use it for productive purposes such as investing in capital improvements and expanding production.

With this in mind, it should be no surprise that the trend in deposits and loans have traditionally paralleled each other; when one goes up, so does the other. But as you can see in the chart below, this relationship has broken down since the onset of the financial crisis. While deposits continue to rise, loans remain at precrisis levels.

Source: FDIC statistics on depository institutions.

The explanation for this breakdown is threefold. First, until recently, many banks had been reluctant to make new loans while they're still working through the toxic mortgages dating to before the crisis. While more traditional lenders like New York Community Bancorp (NYSE: NYB) have been able to rein this in, the nation's largest banks remain ominously weighed down.

In the case of Bank of America (NYSE: BAC) — America's second-largest lender by assets — a staggering 7.5% of its loans are noncurrent. This is double the industry average and over seven times the 1% level that an otherwise healthy institution would report. And the nation's third-largest bank by assets, Citigroup (NYSE: C), has a staggering US$100 billion in potentially toxic loans squirreled away in a much maligned division known as Citi Holdings.

Second, banks are operating under the twin clouds of regulatory and economic uncertainty. On the regulatory side, the biggest banks remain pitched over the implementation of Dodd-Frank, and most particularly its so-called Volker rule, which seeks to prohibit them from speculating with depositors' money in a manner reminiscent of Glass-Steagall. On the economic side, alternatively, all eyes are on Europe, which seems to be on the brink of failure every other week.

Finally, and for understandable reasons, lenders are stockpiling high-quality liquid capital. In the aftermath of the crisis, as already noted, rising loan losses caused many banks to watch as their capital levels depleted. This is the reason so many banks have failed over the last few years, the largest of which, Washington Mutual, was seized by federal regulators in September 2008 and sold to JPMorgan Chase (NYSE: JPM) shortly thereafter.

In addition, due to important lessons learned over the last few years, both domestic and international banking regulators are starting to require that banks hold more and better assets in reserve to help protect against similar crises in the future. Under the new regime, known as Basel III, banks may soon be required to hold 4.5% of common equity, up from 2% in Basel II, and 6% of Tier I capital, up from 4% in Basel II, relative to risk-weighted assets. According to a study from the OECD, this could lower global GDP growth by 0.05 to 0.15 percentage points annually.

Waiting for the recovery
It isn't an exaggeration to say that credit is the lifeblood of our economy. It allows consumers to buy houses and cars, and companies to finance current operations and expansion. Indeed, as we learned when the credit markets seized in the depth of the financial crisis, business literally comes to a stop without credit greasing the wheels of commerce. It's for this reason that all investors should keep one eye on trends in this area, as it's likely here that we'll first see signs of recovery and progress.

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