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Banks May Be Underreserved

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The Wall Street Journal reported today, in “No Worries: Banks Keeping
Less Money in Reserve,” that banks have been lowering their reserves for loan losses to the point where regulators are now beginning to question whether they are adequate.

Now this isn’t exactly surprising. Banks, despite their reputation for being conservative, follow the herd. And it’s virtually a given that, at the end of a credit cycle, they will be in a period of extending loans to riskier and riskier borrowers at a time when they have also lowered their reserves. The incentive, in both cases, is the hunt for more earnings. Riskier credits look most enticing after a period of economic growth, when they look safer than they really are by virtue of favorable recent history. And cutting (the term of art is “reversing”) loss reserves boosts earnings.

What is odd about the WSJ piece is it fails to mention Basel 2, the international agreement governing bank capital adequacy, which may also have something to do with the tougher view banking regulators are taking. The Economist, in a recent story, “A twist or two of Basel,” gives an overview:

Since January 1st many European banks have begun implementing the new rules, which govern how much capital they must set aside to cushion themselves from various calamities….The more capital they must squirrel away to satisfy regulators, the more insulated they are from untoward events—but the less money remains to be put to work in order to make profits.

Happily for the bottom lines of big European banks, regulatory capital is expected to drop under the new regime—perhaps dramatically. Under Basel 2, the amount of capital a bank must sit on depends on the riskiness of its loans and other assets….

Banks in America, on the other hand, are glum. Their regulators have taken fright over studies showing that banks’ required capital could fall by an average of 16% if they embraced the new accord. European regulators are inclined to let regulatory capital fall (subject to the discretion of national authorities). American regulators are not. They have now proposed changes in America’s version of Basel 2 that will delay its implementation until at least January 2009. Under their proposals American banks will be subject to a number of “safeguards” that keep capital cushions plump…. America’s regulators are too uneasy about the Basel 2 project to lighten up. They think the accord relies too heavily on banks’ in-house risk models, which are fallible and “highly subjective”, as one regulator put it. Quietly, some also worry about European banks, which already have much higher levels of leverage than American ones and hold less capital to offset it.

Others fret about a lack of transparency. Under Basel 2, national regulators can force individual banks to boost capital reserves if they see fit. But in Europe it is unclear what an unacceptable level of capital might be, or how bank regulators would react if a bank edged towards it.

There is no such ambiguity in America, where banks have been held to a stringent regime known as “prompt corrective action”. This came into law in 1991 in the wake of America’s savings-and-loan debacle, in which more than 2,900 banks failed. Then, regulators repeatedly threw lifelines to struggling banks, which only postponed their inevitable collapse. Now, they have much less scope for leniency. They must take specific, and increasingly severe, actions—from curbing lending to closing a bank—as a bank’s capital ratios deteriorate. The idea is to intervene before banks get into trouble, and to make the consequences of falling into the red zone clear to banks and investors well before anything bad happens

With this background, the regulatory posture described in the Journal shouldn’t be as surprising as its writers make it out to be:

As more consumers and companies start having difficulty paying their debts, the funds that banks set aside to cover soured loans stand at the lowest level since at least 1990.

The situation is causing consternation among regulators. And as credit quality begins to deteriorate from unusually strong levels, the issue also is causing jitters on Wall Street, where analysts predict the need to boost loan-loss reserves will cut into banking-industry profits this year….

Typically, investors and regulators fret that banks overestimate these charges during good times so they will have a cookie-jar to dip into when times are rougher. Now, though, the worry is that banks haven’t put aside enough money to cover bad loans because times have been so good and because they haven’t wanted to damp profit growth.

In a December advisory, regulators reminded bank executives that they should use the leeway available to them in calculating reserves because “we do believe there is risk building in the system,” says Kathryn Dick, deputy comptroller for credit and market risk at the Office of the Comptroller of the Currency, which regulates banks.

That guidance “was a heads up, a shot across the bow, if you will, to the banks,” said Lynn Turner, managing director of proxy advisory and accounting-research firm Glass Lewis & Co. and a former chief accountant with the Securities and Exchange Commission….

Banks set aside an average of 1.09% of the total value of their loans at the end of last year, according to data from 518 publicly traded banks compiled by SNL Financial for The Wall Street Journal. That is a dip from 1.14% in 2005 and from 1.63% in 1992 and 1.48% in 1990. The SNL figures date to 1990.

“There is a growing concern about loan quality and it isn’t reflected at all in the reserves,” says Brian Shullaw, an associate director at SNL, a Charlottesville, Va., research firm that focuses on the financial-services industry….

Over the past few years, investors have benefited from the lower reserve levels because they helped boost profits. The banks say that they have been draining their reserves because few borrowers have defaulted on their loans. From 2004 to 2006, the nation’s biggest banks received 37% of their earnings growth from reductions in their loan-loss reserves, according to a Feb. 12 Morgan Stanley report. Big regional banks got a bigger boost, with the freed-up reserves accounting for 52% of earnings growth, according to Betsy Graseck, a Morgan Stanley banking analyst.

A number of banks have drawn down their reserves for bad loans to “apparently unsustainably low levels,” according to a recent report from the Center for Financial Research & Analysis, a Rockville, Md., accounting-research firm.

Indeed, banks are expected to soon start reversing course and building reserves amid growing expectations that the boom times are drawing to an end. Although loan defaults and charge-offs remain at historically low levels, bank executives predict that credit quality, which has weakened, will erode further this year.

Ms. Graseck, who is predicting that big-bank earnings will rise 5% this year, estimates that a 10% increase in reserves could reduce that earnings growth by four percentage points.

The trend comes at a time when bank profits are also expected to be hurt this year by short-term interest rates going higher than long-term ones — the so-called inverted yield curve. Banks typically profit by borrowing short-term and lending long-term, so when the yield curve inverts, profit margins get squeezed.

“All of these banks are perfectly sound, but I do think a number of banks will miss earnings estimates based on rising loan provisioning,” says Kevin St. Pierre, a banking analyst at Sanford C. Bernstein & Co.

Historically, banks tend to see their provisions for bad loans increase when interest rates start to rise because higher rates cause problems for weaker borrowers and slow the economy. But that hasn’t yet happened, even as the Federal Reserve has steadily raised rates to a current level of 5.25% from historic lows.

Whether and when banks should take additional provisions for loans that might not be repaid is a point of contention among bankers, regulators and accounting rule makers. Many bankers would like to set aside funds for possible bad loans in good times, forming a cushion for when things get tough. But that isn’t permitted because such moves can be abused to manipulate earnings.

As a result, accounting rules generally don’t allow banks to use provisions as “rainy-day funds.” Instead, they require banks to take a provision when it is “probable” that a loan has gone bad. So, a bank can’t establish a provision for, say, 2% of a loan portfolio just because that is the amount that typically tends to turn bad. Instead, it must assess an array of events that lead it to believe a loss is probable.

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