An emerging phenomenon is coming into the banking landscape. Banks are appearing that are capitally adequate but operationally stressed. These banks have low letter grade ratings driven by weak net incomes. They simultaneously exhibit strong capital adequacy test numbers and large unused credit capacities. In short, their lending engines have idled.
During the second and third quarters of 2008, banks were shutting down new lending as defaults rose and fear gripped the new loan landscape. Stress scenarios computing Maximum Probably Loss (MPL) in turn force many to allocate heavily into provisions for loss reserves further tightening credit availability. The process took several months but the lack of new lending production is now beginning to manifest as degraded interest and fee earnings on loans. That’s the primary source of transaction revenue in the banking industry. So even though these banks have capital, they have no revenue.
Essentially these banks have slipped back into what is effectively a de novo start up configuration. It’s well known that new banks are capital rich and revenue poor. Their business model challenge is to grow lending to reach profitable operational returns. In the Institutional Risk Analytics (IRA) system this tends to make a bank display a bank stress rating we call a “start-up F.” The business stress is real. There’s tremendous pressure on the bank to get the lending engine up and running on a timely basis. Our system generates a special flag for this condition. The logic that triggers flag is appearing for these older banks that have anemic lending.
We have not seen many older strong capital banks drop down into this “de novo like profile” as a phenomenon until recently. But now we believe as much as one quarter (1/4th) of the low rating grades population in our system may be exhibiting signs of underperforming lending engine stress.
The condition is worrisome because during 2008 we saw a number of FDIC resolutions centered precisely around banks that were still capitally adequate but displayed worsening operational stresses. The banks the FDIC resolved often displayed adequate regulatory capital but weak income statements and deepening loan loss trends. We optimized the IRA system to detect the very real threat of regulatory resolution action around this degrading safety and soundness condition.
It’s clear that some banks avoided further loan losses by decreasing or ceasing new loan production. The result was the Fall/Winter 2008 credit squeeze. Time moves on and now the stress has morphed. All bankers know that growing one’s lending base is a tedious process. You make good loans one at a time. So the institutional risk question is can they get their loan engines moving again?
These banks must address the business issue of competing for new lending to bring net income back on stream before cost of capital catches up with them. The fundamentals say these banks need to begin aggressively competing for new loans in order to build up their interest and fees sources of income. We’ve heard a number of anecdotal cases of this beginning to happen. We have adjusted our automated detectors to indicate when a bank is exhibiting this “restart/de novo challenge” condition in our reporting.