With Sun in Their Eyes, Banks Cut Rainy Day Funds

Lower loan loss reserves bolster profits but erode protection. 

Banks see sunny days they don’t think will ever end.

Photographer: Andreas Rentz/Getty Images

Banks have become too safe.

That is a chief justification cited by lawmakers to roll back the Dodd-Frank banking regulations and loosen other financial rules. The Senate passed a bill in March, and Speaker Paul Ryan said earlier this week that he had a deal to push the measure through the House. But at least one layer of protection that banks typically rely on when financial storms come is the thinnest it has been in more than a decade, nearly back to where it was when the housing bust started the downpour that nearly wiped out the big banks.

Planning for Sunny Days

Loss reserves as a percentage of total loans are back to pre-financial crisis levels

Source: Bloomberg

Bank of America Corp.’s loan loss reserve, the rainy day fund that banks set aside to cover potential defaults, shrunk at the end of the first quarter to just 1.08 percent of its overall loan portfolio. That’s lower than its lowest point in the run-up to the financial crisis — 1.19 percent in mid-2007. Wells Fargo & Co. currently has the lowest ratio of reserves to total loans of its rivals, at 1.07 percent, though its still slightly higher than the less than 1 percent it was in late 2007. Increasingly, those rainy day funds have become a source not of protection but profits.

In the first three months of the year, the nation’s four biggest lenders, which includes JPMorgan Chase & Co. and Citigroup Inc., drained a collective $993 million from their their loan loss reserves, boosting bottom lines. Wells Fargo accounted for nearly two-thirds of that, lowering its loan loss reserves by $631 million in the first quarter. Wells Fargo also booked a provision for loan losses in the quarter of just $191 million, another way to boost profits. That was by far the smallest of all the big banks. Citi’s loan provision in the quarter was nearly 10 times larger at $1.8 billion, but that, too, was down from the $2 billion in the prior three months.

Less in Reserve

Banks cut their loan loss rainy day funds by nearly $1 billion in the first quarter

Source: Bloomberg

While the rainy day funds are down, what’s also true is that there have been few credit clouds, and most expect the economy to remain sunny. Bank of America, in particular, has recently been staying away from the biggest problem areas of lending, which has resulted in lower loan losses than rivals and perhaps less of a need for reserves. Overall, the net charge-off rate at 0.55 percent of all bank loans in the last quarter of 2017 was up slightly from a year before, but it’s still a quarter of the 2 percent it was in 2008.

Capital Strength

Capital ratios at all of the big banks are up considerably from before the financial crisis

Source: KBW Research

Tangible common equity as a percentage of tangible assets.

Capital ratios are considerably higher than they were a decade ago, which is what most people point to when they say the banking system is safer. Some analysts have cheered the lower reserves because it will bolster lending profits, which is why banks try to hold as little reserves, and capital, as possible.

But with small reserves, which take the first hit when loans go sour, bank’s profits could be vulnerable, even if the higher capital ratios make failures less likely. What’s more, reserves are a key component in the Federal Reserve’s annual stress tests, so regulators could require more capital if reserves get too low. But the biggest issue is that after the financial crisis, many said regulations were needed to compel banks to be more countercyclical, building up capital and reserves with their higher profits in good times so that they could weather future storms. That’s sort of worked for capital. But now that regulators seem ready to permit bankers to let down their outer defenses a bit, investors will see there is a lot less weather-proofing.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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