When talk turns to the economy rebounding, the discussion tends to center on unemployment, the housing market or the age of cars on the road today, but loan loss allowances – those funds banks set aside to cover loans gone bad – tell their own story.
According to the Federal Deposit Insurance Corporation’s most recent quarterly banking profile, reduced loan loss provisions accounted for the biggest positive contributor to year-over-year earnings at insured institutions nationwide during the first quarter this year. American banks collectively socked away $7.6 billion for loan loss allowances – about $3.3 billion less than the year-ago period and marking the 18th consecutive quarter of reduced loss provisions. The FDIC said 42 percent of banks reduced their loan loss provisions during this period.
Put it down to the natural ebbs and flows associated with the recent financial crisis and ensuing economic recession, industry observers say. The downturn shook out bad borrowers, and banks tightened up underwriting standards.
Charge-offs and noncurrent loans also fell year-over-year. Net charge-offs fell for the 15th consecutive quarter to $10.4 billion, a year-over-year decline of $5.5 billion, or about 35 percent. Noncurrent loan and lease balances declined $12 billion, or almost 6 percent, to $195.1 billion, making this year’s first quarter the first time since 2008 that noncurrent loans and leases have fallen below $200 billion, the FDIC said.
The coverage ratio, of loan loss reserves to noncurrent loans and leases, also improved to 67.8 percent across the industry and 91.2 percent at community banks specifically. Massachusetts banks are even more conservative, if the numbers are any indication. During the first quarter this year, Bay State banks boasted a coverage ratio of 113.58 percent, up from 92.14 percent this time last year. Even in the depths of the recession, during the first quarter of 2009, Massachusetts banks maintained an average coverage ratio of 81.07 percent.
Too Much vs. Not Enough
There’s no point in overfunding your loan loss allowances, but Kenneth Ehrlich, a partner with the Boston law firm Nutter McClennen & Fish, says this has been a point of contention between banking regulators and the Securities and Exchange Commission (SEC) in the past, and public bank companies would do well to take heed.
Regulators, of course, would rather see bankers overfund loan loss allowances than underfund them, but the SEC has run into problems with publicly traded banks overfunding loan loss allowances and later using that excess provision, through a reverse provision, to manipulate earnings in a down quarter. Notably, the agency has butted heads with SunTrust, accusing the Atlanta, Ga.-based bank of overstating its loan loss reserves.
“Indeed, there’s a balance, but that’s very much dependent on economic conditions. You cannot expect for banks to have the same level of loan loss reserves as in the depths of the recession,” commented Ned Gandevani, a professor in the MBA and MFS programs at the New England College of Business. “As the economy is getting better it would be more rational and expected to reduce that. Otherwise, it would be a waste of resources.”
Meanwhile, new rules proposed by the Financial Accounting Standards Board (FASB) could impact how much banks set aside for loan loss allowances, although it’s unclear right now exactly how those rules will affect community banks’ loan loss reserves.
In essence, the board has proposed shifting from an incurred loss model, which estimates loan loss allowances largely based on historical losses, to a current expected credit loss model, which takes into account future data, for instance an anticipated drop in unemployment rates, said Dan Morrill, a principal at the Boston-based accounting and financial services risk management firm Wolf & Co.
“I think the idea was to simplify the impairment model,” Morrill said. “I think it makes sense to be able to look to the future.”
Whether those new rules will propel bankers to beef up their loan loss reserves or scale back their rainy day fund is yet to be seen.
Thirty-eight percent of bankers responding to a 2013 survey conducted by the tax and consulting firm McGladrey said they anticipated the proposed credit impairment model would have “little to no impact” on their own ratio of allowance for loan losses to total loans. Twenty-nine percent of bankers answering the same question said the new model might cause them to increase the ratio by 50 basis points.
“It’s hard to say at this point what the impact will be. They’re not final yet, and they could always throw in another wrinkle somewhere,” Morrill said. “That’s the big question everyone wants to know: Will it increase the allowance? Will it decrease it? We’ll have to wait and see. That’s the million-dollar question.”
Email: lalix@thewarrengroup.com
