Banks Have Just Lost Their Biggest Profit Center – What Will Replace Billions of Profits from Loan-Loss Releases?

During the past five years bankers have reaped billions of dollars in profits by simply making accounting entries instead of making loans.

What was the biggest source of banking industry profit growth over the past five years?  As noted repeatedly in FDIC Quarterly Banking Profile reports, the biggest contribution to earnings growth has come from the reduction in loan-loss provisions.

This from the June 2011 FDIC Quarterly Banking Profile:

FDIC-insured institutions reported net income of $28.8 billion in second quarter 2011, an increase of $7.9 billion (37.9 percent) from a year earlier. This is the eighth consecutive quarter that industry earnings have improved year-over-year, but it is the smallest such improvement in the past seven quarters. Lower expenses for loan-loss provisions were the principal source of the increase in quarterly net income.

Loan-loss provisions totaled $19 billion, a decline of $21.4 billion (53 percent) from second quarter 2010. This is the seventh consecutive quarter that provisions have declined from year-earlier levels.

Two years later the FDIC comments in the June 2013 Quarterly Banking Profile were nearly identical to those made two years earlier.

As we have noted previously, declining loss provisions have been a primary driver of earnings growth in the industry in recent years.  However, the red line in the next chart shows that the decline in loss provisions has been largely exhausted.  In future quarters, earnings will be increasingly dependent on revenues.

Chart 4 - Quarterly Revenue and Loan-Loss Provision, 2009-2013

The green bars in the chart show that industry revenue has grown by less than two percent over the past four years.  The primary reason for the industry’s slow revenue growth is the ongoing erosion of net interest margins in a low interest rate environment.  Net interest income totaled 103.7 billion dollars in the second quarter, the lowest since fourth quarter 2009.  And the net interest margin of 3.26 percent is the lowest since third quarter 2006.

The banks wound up over reserving for loan losses during the darkest days of the banking crisis during 2006-2009 when it seemed like almost every loan in their portfolios would wind up defaulting.  As the economy stabilized and asset quality improved banks were able to reduce their loan-loss reserves which boosted profits.

Going forward banks are going to have to earn profits the old fashioned way by making profitable loans.  The third quarter of 2014 marks the end of profit gains by reversing loan-loss reserves.  Banks actually set aside $7.2 billion in provisions for loan losses during the third quarter which is the first time in five years that the banking industry reported a year-over-year increase in loan-loss reserves.

Year-Over-Year Change in Quarterly Loan-Loss Provisions

For the past five years, reductions in loan-loss provisions have been the most consistent contributor to earnings growth. However, as this chart shows, third quarter earnings did not get a boost from lower provision expenses. Instead, loss provisions were 1.4 billion dollars higher than a year ago. This is the first year-over-year increase in quarterly loss provisions since the third quarter of 2009.

Fortunately for the banking industry revenue and loan growth seem to be kicking in at just the right time as Banking Industry Profits and Revenues Show Strong Increase in 2014 Third Quarter.

Have banks optimistically over reduced their loan-loss reserves as they did just prior to the banking crash of 2006-2009?  The total loan loss reserves of the banking industry now total just 1.53% of all loans compared to the pre-banking crisis level of 1.69%.

Looking at other factors such as improved asset quality and the coverage ratio for noncurrent loans, the total loan-loss reserves look more than adequate if the economy continues to improve.

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