Short of capital and struggling to keep their heads above water, American banks are continuing to cut lending as the economy continues to sag. It’s typical of what happens in a banking-led slump, it’s also what the US economy doesn’t want to see happen. And it’s inevitable.

According to the US Federal Reserve, its July survey of senior bank financial officers showed that this tightening process was across the board: from home loans, business lending to credit cards and other personal loans. This tightening has become more pronounced in the past three months.

There are strong signs this tougher attitude will continue into the first half of next year, a sign that the US banking system is still retreating to try and rebuild capital and their businesses after being badly damaged by the subprime mess and credit crunch.

It’s exactly what our banks did after the last recession in 1991-92. Our banks cut lending, raised standards and spent several years rebuilding capital reserves and restructuring their businesses.

In the US there is one very important difference: American banks remain on the Fed’s funding teat. In the week to last Wednesday the Fed had lent an average $US17.4 billion a day to the country’s banks. That was on top of the $US150 billion in the so-called “term auction” facility which is rolled over every 28 days to maintain liquidity levels in the economy.

When confronted with that situation, the latest Fed survey paints a picture of a crippled financial system, unable to maintain its own viability: it would seem the current strengthening on Wall Street is being effectively financed by the Fed, along with most commercial transactions at the moment.

The Fed’s survey, which it carries out four times a year, showed that the percentage of US banks reporting tighter lending standards rose across various loan types in its July survey when the percentage of banks reporting tighter lending standards was already near historic highs.

Now this situation seems to have worsened for borrowers. In the July survey about 75% of the banks surveyed indicated they had tightened their lending standards for prime home mortgages. That was up from about 60% in April.

Meanwhile, Fannie Mae and Freddie Mac, the two huge US mortgage funders who are responsible for around 80% of all mortgage financing at the moment, are raising fees and cutting back on lending to the low doc segment of the market at the very time that more lending is needed to stop the relentless fall in US home prices from continuing because of a growing oversupply of unsold houses.

Many banks reported that they would be tightening their standards, cutting back on lending, or maintaining current levels of restrictions in the first half of next year.

It’s not going to get better quickly. For the US economy to enjoy an upturn in growth, with low inflation, it needs a functioning, well capitalised banking system. It doesn’t have that now, and won’t have it for some time.