US banks - how they got into such a mess

Some loans always go bad. It is an unavoidable fact that all bankers must confront. Sensible bankers take precautions; they build up loan provisions, so when borrowers default, the loss is covered.

Loan provisioning directly affects bank profitability. If a bank stashes some cash away to cover a loss, it can not also distribute that cash as profits. Although loan provisioning creates some complex tax issues, in general banks don't like to defer large amounts of cash to cover potential losses.

How much cash has the troubled US banking system saved up to cover potential losses? Back in the early 1990s, US banks put away the equivalent of 2.6 percent of total loans as loan loss provisions. Since then, the ratio has fallen steadily. It reached a low in 2007, when the ratio fell to just a fraction over 1 percent.

However, the subprime crash has caused banks to suddenly reverse this policy. In the last couple of months, banks have been rapidly increasing their provisioning. Presumably, the Fed has advised US banks to prepare for an uptick in losses.

However, where the banks right to economise on their loan loss provisions? Did loan losses fall during the early 2000s, thus justifying the reduction in loan provisioning?

Not really, after the S&L crisis subsided in the early 1990s, net loan losses fell. However, by the mid-1990s, net loan losses as a proportion of total loans fluctuated somewhere between 0.5 and 1 percent of total loans. For most of this decade, net loan losses were either higher or at comparable levels to the 1990s. Actually, net loan losses peaked at over 1 percent around 2002. In short, net loan loss rates gave the banks little justification for economising on loan provisioning.

Subtracting the two numbers gives some idea about how capacity of US banks to absorb losses. As the chart below illustrates, the margin between loss provisioning and net loan losses has narrowed considerably over the last ten years. Take a look at the last data points; it shows that the provisioning buffer has narrowed quitely sharply in the last couple of months. This indicates that despite the increase in provisioning, US banks are finding it difficult to cover the upswing in net loan losses.

Presumably, behind these numbers is the well-known story of mortgage securitization, increased subprime lending, and self-certification loans. If banks could off-load risk to others, then lending volumes could increase.

The numbers also show that US banks are struggling to absorb losses. The really frightening thing is that the existing level of net loan losses were accumulated when US economic growth was high, while unemployment was low. When the US economy begins to seriously slow, then net loan losses will skyrocket. US banks are simply not ready for this.

No wonder the Fed is so keen to keep interest rates low.