Nothing In Reserve at Commercial Banks

Although yesterday's China-inspired plunge in global share prices on extremely heavy volume is no doubt the story of the day, another equally ominous, though less headline-grabbing development was also being reported in the pages of the nation's business newspaper.

In "No Worries: Banks Keeping Less Money in Reserve,", The Wall Street Journal makes it clear that commercial banks in the U.S. are no less exposed to a sudden and unwelcome change in the risk equation than their less well regulated and often denigrated clients, competitors, and counterparties, including hedge funds.

Banks might be putting too much faith in their borrowers.

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.

Banks establish reserves for a portion of loan portfolios or big individual loans that they estimate could go unpaid. The reserves ensure that banks have enough capital to cover any losses from loans that go bad.

But each increase in those reserves results in a charge that cuts into banks' profits.

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.

The low reserve levels aren't triggering any concern about the financial soundness of the nation's banking system. Bank failures are quite rare. When regulators closed a small bank near Pittsburgh this month, it was the first bank failure since June 2004.

Still, the current level of loan-loss reserves is reigniting a longstanding debate among regulators about how banks calculate the amount of money to put aside for bad loans and the appropriate time to do so. The Financial Accounting Standards Board has recently started to consider whether banks should be required to disclose more information to investors about the way they calculate reserves....

"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....

Investors will feel the pain if banks boost reserve levels.

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.

This story is all the more worrying in light of other news that crossed the tape earlier today. According to Bloomberg, "the Federal Reserve said that the delinquency rate on banks' residential real-estate loans climbed last quarter to the highest level in four years."

The share of the loans on which payments were at least 30 days overdue rose to 2.11 percent, the highest since the fourth quarter of 2002, from 1.72 percent the previous three months, according to data posted on the Fed's Web site today. The data aren't adjusted for seasonal patterns.

The deterioration in credit quality comes in a period of sustained gains in employment and incomes, a sign that weaker underwriting standards, not economic stress, may be to blame. Fed policy makers this year have repeatedly said that mortgage losses were concentrated in subprime loans, which are designed for lower-income borrowers.

"The real issue here is whether this is a story confined to a small portion of the household sector or is this something that becomes a broader macroeconomic story?" said Brian Sack, a former Fed economist who is now a vice president at Macroeconomic Advisers LLC in Washington. "Some households are in trouble."

And as we shall soon see, so are a number of economies, capital markets, and financial systems around the world.