Hugh, it’s been very busy … several trips and all that one has to do at quarter-end as a publicly-owned bank. But I want to update you and your readers about what is happening in banking.
The biggest factor (besides the economy) for banks right now is the regulators. They have clearly shifted into high gear. The regulators have made mistakes and those errors have been highlighted by the Inspector General. Now, in order to cover their rear ends, they are pushing the banks they regulate very hard. The examiners are assuming the worst case scenario and are very critical of loans they review.
By significantly downgrading loans, banks must increase their loan loss reserves, which reduce earnings and capital. At the same time, regulators are increasing the amount of capital that banks need to have in order to maintain their ratings. Weaker ratings lead to the need for more capital, higher FDIC insurance cost, and the strong likelihood of formal agreements and prompt corrective actions.
A loan will be severely criticized if the original projections are missed (most likely in a recession). At that point a new appraisal is required. As you might expect, the value is lower and therefore a pay-down is needed to maintain loan-to-value. At the absolute worst time the borrow must come up with more equity or the bank must write down the loan thus requiring more capital.
Another consequence of this regulatory pressure is reduced loans. As regulators pressure for increased capital, the easiest way to do that is by not replacing loan payoffs. In better times, bankers sold loans or transferred them to off-balance sheet entities to sustain capital. That’s not possible today. However, the administration’s new PIPP plan is a vehicle to sell loans. The capital pressure may push more banks to sell loans into that program at prices buyers may be willing to pay. Of course as banks take losses over and above what they have written the loans to, they will need more capital and the vicious cycle continues.
Another way to increase capital is to reduce costs. Many banks are in a cost cutting mode, which means they are reducing their biggest expense-personnel cost. Staff reductions of ten to fifteen percent are common. Staff reductions without consolidation are a short term fix and with fewer calling officers banks will further reduce lending and other services.
As I noted above, the regulators and Treasury are assuming a worst case scenario, which brings me to the “stress tests”. While only 19 banks have been “tested”, it is likely that the “tests” will be applied to many more banks. The concept is nuts. By assuming the worst case, you create it-a self-fulfilling prophesy! By requiring more capital in the middle of a recession, the regulators will prolong the recession or make it worse. The idea of a stress test came from what some on Wall Street were doing in a so-called “burn-down” analysis. Without earnings as a guide, analysts were looking for a method to find the bottom value of bank stocks. For regulators to use this concept and require more capital based on the results is crazy. I think they figured that out after they announced the “test”, but by then they were trapped. My guess is that they sacrifice a couple of lambs (Regions and Fifth Third) and a goat (Citi) to get out of the jam.
A fairly easy answer to the mess Treasury and the regulators have created is “capital forbearance.” This concept has been around for years and was used in the ’80’s. When bank management appears to be capable, capital forbearance will be more effective than liquidating assets or banks at fire sale prices. Furthermore it does not create procyclical forces to push the economy deeper into recession.
My email is BankerGuy2009@gmail.com