THE BANK PROFIT MIRAGE REDUX
On December 1, 2009, we posted a piece here looking at the 3rd quarter FDIC Quarterly Banking Profile, which contained one of our favorite charts. The FDIC released the 4th quarter report on the banking sector today, so we update the chart and present it below. It shows the relationship between noncurrent loans and leases and the level of loan loss reserves available to protect bank capital from losses. The coverage ratio is simply the loss reserve as a percentage of noncurrent loans and leases.
Let’s keep this short and sweet. The coverage ratio fell to 58.1% from 60.1% in the previous quarter and 75.3% a year ago. The quarterly provision for loan losses, which is added to the reserve pictured above, is an expense that comes out of earnings. Even as the FDIC says in its own press release that “asset quality indicators worsened in the fourth quarter” and that net charge-offs (NCOs) increased by roughly $2 billion in the quarter, the provision for loan losses fell by $1.7 billion from the previous quarter. The provision collectively made by the banks in the 4th quarter is the lowest since the 3rd quarter of 2008. At this point we will call attention to the top two headlines on the FDIC press release:
- Industry Reports Fourth Quarter Net Income of $914 Million
- Loss Provisions Remain High but Register First Year-Over-Year Decline in More Than Three Years
We present a few bullet points in response:
- If the coverage ratio had simply held steady at 60.1% (a number we believe is ridiculously low to begin with), banks would have increased the quarterly provision by $7.6 billion, easily erasing the $914 million in “profits” for the insured banks. How regulators can continue to allow the banks to show positive earnings through underprovisioning is a mystery. When we consider that the average coverage ratio since the early 1990s is well north of double the current ratio, it’s hard to consider the banking system to be well-protected against potential losses. The only rational reason to reduce provisions today is if bankers believe that they are already adequately reserved and that losses will be subsiding. The FDIC doesn’t even believe that. Sheila Bair told Bloomberg News today that “The pace [of bank failures] is going to pick up this year and is going to exceed where we were last year.”
- It is incongruous to celebrate the first year-over-year decline in provisions in the same press release in which it is stated that “this is the 12th consecutive quarter than NCOs have posted a year-over-year increase.”
great post. thanks
this post is what makes the tpc blog so good
however, inquiring minds wonder to what extent the provision shortfall is concentrated in FDIC watchlist banks, or whether under-provisioning is endemic across the board, which would better prove the over-reporting of income point…in other words, does the old 80/20 rule apply here too?
Great points raised. The only question I have is, given that the coverage ratio always declines during recessions (as presumably banks feel that the true level of charge offs is reached and therefore there is no need to overprovision as in non-stressed times), how do we know what an appropriate coverage ratio is at this point?
For example, if we think that deliquent loans have neared a peak value, the coverage ratio should represent the expected level of losses from currently non-performing loans. So if banks are assuming that losses on nonperforming loans will be around say 50% and we are almost but not quite at the peak level of nonperforming loans, then a coverage ratio of 58-60% may be appropriate.
I don’t mean to criticize the excellent point raised here that bank profits esp. at this junction are highly dependent on an opaque set of assumptions (banks are black boxes) and therefore these “profits” may be nothing but accounting fiction, but it’s also hard to say whether the coverage ratios are indeed inappropriate. At a minimum, this analysis does show that if you think nonperforming loans are not close to peaking (this is particularly the case for CRE, but many have made the argument for residential real estate as well) then banks are in for a world of additional pain given how thin the provisioning currently is.