Let us give thanks for the industry’s 3Q results, which showed a bit of welcome profit and capital improvement. However, even as we do so, we shall bow our heads in prayer for 4Q and quarters to come. Details in the 3Q results show how serious remaining challenges will prove. More bank failures are certainly to come, but an even larger problem is, we think, losses building on even the biggest banks’ balance sheets without enough reserves to absorb them.
In fact, even the good news doesn’t stand up under scrutiny. While the industry swung to overall profit in the third quarter from large losses in the second one this year, we think these results distort the true condition of the industry. Given the huge amount of asset concentration in the banking system, a good quarter from Goldman Sachs and JP Morgan Chase – which of course they had – skew overall industry results. Look, for example, at the fact that, even though industry profit was up 300 percent from the third quarter of 2008, slightly more banks showed a loss than during that same, awful period a year ago. And, we are similarly dismal about the capital numbers. They are nice to see – we’ve learned the hard way that banking-industry data can be worse. However, the slight improvements in regulatory capital largely result from the dramatic rewrite in bank assets. Holdings at the FRB went up a surprising 37 percent from the second to the third quarter and Treasury investments went up an even more stunning 49 percent over just three months. Since the risk-based capital requirement for these holdings is zero, it’s obvious what this does for the critical risk-based ratio. Add to these holdings the large balances banks laid in with Ginnie Mae’s (also a zero risk-based requirement) and GSE securities (which bear only a twenty percent weighting), and it’s clear that banks are desperately rejiggering the books to keep capital ratios up even as loan losses exert ongoing downward pressure. This keeps the banks’ nose above water, but worsens the recession because no new loans – which have far higher risk-based capital requirements – are being made to spur investment and, then, employment.
In fact, one of the most troubling signs we see in the FDIC report is another capital play: the drop in loan-loss provisions – the critical cushion between bad loans and the FDIC’s grim reaper. The FDIC release touts reserve increases year over year. However, from 2Q to 3Q, provisions dropped $4.8 billion, seven percent. To be sure, overall reserves were up four percent for the quarter, but we think this is just a temporary reprieve in the numbers that doesn’t buttress the industry’s ability to absorb growing losses. The best the FDIC can say on this front is that the number of problem assets isn’t growing as fast as once it did. Still, during the third quarter, non-current loans and those in non-accrual rose to $367 billion or almost five percent of all loans and leases. This is a record since the FDIC started to gather data in 1984 – topping even the worst years of the S&L debacle and the real-estate crisis that succeeded it.
To get happy, we would want to see total reserves close to a reasonable ratio of likely losses and then some. We’re old enough to remember the reserving rule in which banks put dollar-for-dollar up for losses into a “specific” reserve for loans they know are at risk and then added to the specific ratio a “general” one of at least one percent of total assets. This ensures that anticipated loan losses would not ding capital and built in a reasonable cushion for unanticipated losses.
Current reserve ratios are way, way below this traditional standard, which means that losses will continue to outrun capital at the most troubled banks even if assets are moved as quickly as possible out of loans and into government securities. A vicious cycle could well be building in which, the more troubled the banks, the less they provision to preserve capital (they hope) and the less they lend. The only way to forestall this downward spiral is for regulators to force tough calls – close the growing number of dud banks now, demand higher reserves as quickly as possible at banks that can bear them, remove troubled assets to the greatest degree possible from viable institutions and cross their fingers for the macroeconomic recovery to come.