Under-provision: US banks are waking up to a riskier future

Liseth Galvis-Corfe - 20 September 2018

After the financial crisis, US banks increased substantially their loan loss provisions (figure 1). Since then low interest rates have supported economic growth through leverage. Now that the Federal Reserve has tightened monetary policy, the decrease in loan loss reserves is worrying. Loan loss reserves as a proportion of total loans have dropped from 3.70 per cent to 1.22 per cent between March 2010 and June 2018. If we are approaching the end of the credit cycle, banks are ill-prepared for a shock derived from an increase in impaired loans.
After the global financial crisis, regulators made mandatory provision requirements against loans on expected losses in accounting standards (IFRS). Before this, the requirements were based just on current balance sheet losses, excluding probable future losses. Despite these requirements, loan loss reserves are at the same level as they were before the financial crisis.
In a 2017 report from the Bank for International Settlements, The new area of expected credit loss provisioning, the authors look at loan loss provisions and impaired loans for different regions. In aggregate, they found that the gap between the two variables has widened since the financial crisis (figure 2). For the US, the UK, Spain and other advanced European economies, impaired loans have surpassed loan loss provisions in the period 2011-16. Australia is the only country where the gap between the two variables has not increased substantially.
Banks have reduced loan provisions to boost profits. According to Bloomberg, in the first quarter of 2018, three of the biggest US lenders sliced a total of US$993m from their loan loss reserves.  The biggest reduction was from Wells Fargo (US$631m), followed by JP Morgan (US$229m) and Bank of America (US$133m). With the robust economic growth in the US, banks don’t expect credit defaults yet. However, credit card charge-offs have been rising for 2 years. Banks have responded by switching residential loan reserves to credit card reserves, but in an economic downturn, the general level of provisioning must be raised.  The current minimal level of loan loss reserves could easily pose a threat to financial stability.
The need to increase bank profits has intensified this year because bank shares have underperformed. In 2018 Wells Fargo’s share price has decreased by 17 per cent, the reduction for JP Morgan has been 1.5 per cent and 5.4 per cent for Bank of America. Bank profit margins have been affected by the era of low interest rates because the gap between what they can charge on loans and what they must pay for deposits has reduced. Additional factors such as a decrease in profits derived from the transition from branch services to digital services have also affected revenues.

A paper from the World Bank (Laeven and Majnoni) states that banks on average create little provisions in good times and are then forced to increase them during cyclical downturns, magnifying losses. It seems that this will be the scenario in the next downturn; as soon as we see that banks increase substantially their provisions, this will signal that we have reached the end of the credit cycle. 

Figure 1

Data source: FRED

Figure 2

Data source: Bank for International Settlements  

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