Shrinking reserves means no more lazy lending

Jan 22, 2015

Blog URL:

http://www.sageworks.com/blog/post/2014/08/07/Shrinking-reserves-means-no-more-lazy-lending.aspx

Though the last half decade has been rather tumultuous, recent bank metrics released by the Federal Reserve indicate improving credit quality. One of the most notable metrics is the average Loan Loss Reserve ratio.

This ratio, which from 2010 to 2014 has shrunk over 200 percent, measures the amount of the ALLL reserve with respect to the total loan portfolio, and has a strong correlation to overall credit quality. When high, banks believe there is a high probability that loans will become impaired, or they are uncertain about the current conditions of their portfolio. Thus, they maintain a sizable ALLL reserve to mitigate any expected credit losses. On the contrary, when sentiment of the portfolio is good and fewer credit losses are expected, a lower amount is withheld in the Loan Loss Reserve.

A common benchmark used by banks to maintain appropriate Loan Loss Reserve ratios is to compare their Loan loss Reserve fund to the actual average loan loss rate during the preceding five year period. The average Loan Loss Reserve ratio for U.S. banks in Q1 of 2010 was 3.7 percent, indicating a relatively wary and lending-averse environment. This is not surprising, given that the actual average loan loss rate from Q1 2005 to Q1 2010 was quite volatile, and at times, very high.

Since then, however, that ratio has declined to 1.7 percent (Q1 2014), which represents the lowest average Loan Loss Reserve ratio since 2008, before the recession. As credit quality has improved and as we have seen less loan losses during recent years, the Loan Loss Reserve ratio has been shrinking in line with the trend of improving credit quality. This is supported by examining the bad loans to gross loans ratio; it was at 5.6 percent in Q1 of 2010, but has seen a marked decrease down to 2.5 percent as of Q1 2014.

So what does a shrinking reserve mean? Surely it’s a good thing – right?

Loan Loss Ratio

By and large these numbers are promising for the economy. The numbers mean that fewer loans have defaulted in the recent past and banks believe their current loans outstanding will be paid back in full in higher percentages than in preceding years. For banks, it simply means that they have a little less “cushioning” as their Loan Loss Reserves get lower and lower. When ALLL reserves are high and when economic conditions are slowly improving, any release in Loan Loss Reserves serves as a sort of “boost” to the bottom line, as it goes directly to net income. When ALLL reserves closely mirror current economic conditions, as is becoming the case in recent quarters, banks will have to depend on their lending operations for income, and will not have the “boost” of releasing reserves.

This, in theory, means banks must actively lend in order to maintain the desirable profit and loss statements they’ve been enjoying as of late, thanks in part to reserve releases. Without the cushion of Loan Loss Reserve releases to bolster the bottom line, an increase in lending must occur to bridge the gap, and banks cannot be “lazy” in their lending policies, as they will play an increasing role in banks’ performance as economic metrics continue to point to recovery.

I mention this with a caveat, however. Despite recent indicators favoring recovery, banks have been very hesitant to release reserves, and they are still using their qualitative factors to keep reserves relatively high with respect to the current climate. If the economy were to turn and/or interest rates were to rise (which is still a concern in the industry), ALLL levels would again spike. With this concern in mind, banks are not necessarily rushing to release reserves, knowing an economic downturn would merit future provisions to the ALLL. Simply put, they want to maintain ALLL levels to offset the concern of a future downturn.

Also, despite favorable economic indicators, loan demand is still trailing pre-recession levels, and banks are taking a more cautious approach to lending, thus ALLL reserves are not likely to decrease further in coming months. This hesitation, coupled with knowledge of impending regulatory changes in the FASB’s CECL model, means that banks have a vested interest in keeping reserves at a conservative level in today’s economic environment.

To sum up, we have undoubtedly seen a decrease in ALLL reserves as conditions have improved, and this has had a favorable impact on both banks’ net income and qualified borrower’s likelihood of acquiring loans. However, banks’ hesitation to release reserves and their use of qualitative factors to bolster the ALLL imply that we have not yet reached a point of economic certainty.

Some institutions can make the case that further releases in the Loan Loss Reserves are merited. For those institutions that wish to make a change to their Loan Loss Reserve levels, our whitepaper How to Support a Change to the ALLL Reserve will guide them in evaluating whether a change can be substantiated and inform them of best practices on how to support and document a change.

Support a Change to the ALLL Reserve