Lessons on loan provisions and bank charge-offs

Amidst all the macro papers, it is always nice to read a bit about micro especially banking practices. FRBSF economists Fred Furlong and Zena Knight in this short note look at two problems of banks:

• Underestimation of risks from housing sector
• Because of first, banks kept lower loan provisions and charge-offs

The authors compare the rise in nonperforming loans in residential anc commercial housing markets across previous recession. In this recession what stands out is the rise in non-performing residential property loans. In Commercial loans, we saw similar rise last time as well. After this they look at underprovisions etc. So once the housing prices fell, banks which were seen as adequately capitalised were found to be very weak (nearly insolvent).

So what are the lessons? Proper stress tests which look at adverse scenarios:

The recent financial crisis and recession have painfully demonstrated the vulnerabilities associated with the bank loss-provisioning process. It’s clear that provisioning should be more forward looking. However, even a more forward-looking provisioning process would not have fully addressed bank vulnerability to the extraordinary events of the past few years. By definition, loan loss reserves are designed to absorb expected losses. Even if banks had better forecasts and more discretion in setting reserves, they would probably still be unable to adequately provision against unexpected large economic shocks. Guarding against such shocks is the role of capital. The lesson of the financial crisis is that the buffer against downside risk must come in the form of higher bank capitalization.

This is in keeping with the principles underlying the Supervisory Capital Assessment Program applied to the 19 largest bank holding companies in the spring of 2009 (see Board of Governors 2009). The program tested the financial status of these organizations under much more adverse economic and financial market conditions than expected. In other words, the stress tests focused on what would happen in cases of significant unexpected losses. The results indicated that the level and quality of capital at some banking companies was probably not sufficient to allow them to weather severe economic conditions and still actively provide financial services. Accordingly, these organizations were required to raise capital.

WSJ Blog mentions the paper as well

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