Bank credit allowances indicate calm as charge-offs rebound

Banks' loss provisions are sending a signal of relative confidence over credit performance even as bad loans bounce sharply off pandemic lows.

The loss allowance ratio at US commercial banks ticked up 8 basis points from the end of 2022 to 1.71% at the middle of 2023, according to data from S&P Global Market Intelligence. Meanwhile, net charge-offs (NCOs) — loan amounts that banks determine are uncollectible — surged to $24.71 billion in the first half of 2023, nearly matching the $26.71 billion in all of 2022.

Banks' allowance levels are largely bound by current conditions and mainstream economic forecasts. While NCOs appear to be rapidly reverting to pre-pandemic norms, key factors like employment remain strong and fears over a hard landing as the Federal Reserve tightens policy have broadly receded.

The amount of additional money banks are putting into allowances to cover loan losses does indicate that the industry anticipates further "normalization." Credit provision expenses exceeded NCOs by 56.42% in the first half, a period marked by relatively soft loan growth, which also drives provisions. However, compared with an allowance ratio of 2.37% at the end of 2020, the current outlook is far more benign than the catastrophe that seemed possible early in the pandemic.

Hot spots

A return to normal does put credit performance in reach of something worse, to be sure, and there are areas of particular concern.

Many questions center around the strength of the consumer as a pandemic surge in savings continues to drain away.

Consumer loans, excluding residential mortgages, are also a focus simply because they drive most loan losses. They accounted for 51.72% of total NCOs across commercial banks since 2006, according to Market Intelligence data. Single-family residential loans were also a major source of losses during the Great Financial Crisis but have become much more reliable, generating net recoveries of $1.87 billion since 2019.

Credit card loans, which account for about half of commercial banks' consumer loans, are unsecured and tend to generate high loss rates, though they also produce high yields — annual percentage rates charged by commercial banks hit 20.68% in May, according to data from the Fed.

The card NCO rate across US banks reached 3.54% in the second quarter, up from a low of 1.70% in the fourth quarter of 2021 but still below 3.91% in the fourth quarter of 2019, before the pandemic.

Meanwhile, work-from-home trends are helping to force a reckoning in the office sector, and many lenders have lifted allowance ratios for office commercial real estate (CRE) loans to close to double-digit percentages. In the much broader CRE sector overall, the commercial bank allowance ratio increased 17 basis points from the end of 2022 to 1.41% as of the middle of 2023, compared with 1.96% at the end of 2020.

In commercial lending, bankruptcies have rebounded close to pre-pandemic levels, according to a tally by Jefferies analysts. "While bank commentary says that commercial credit remains healthy and is normalizing as expected, one-offs are showing up," they said in a Sept. 18 note.

Those one-offs include a string of banks that reported losses in September that appear to be driven by the wipeout of the same shared national credit to an oil distributor.

Recessions are hard to predict

While allowance levels bespeak a relatively sanguine take on the economy, they do not necessarily reflect the anxieties and personal views that senior bank executives hold about what may be around the corner.

Things are "pretty good" for businesses and households currently, JPMorgan Chase & Co. Chairman and CEO Jamie Dimon said at an investor conference on Sept. 11, citing income growth and household net worth boosted by strong home and stock prices.

But Dimon put himself in the camp that views the current situation as similar to the 1970s, with risks including heavy deficit spending by governments and geopolitical supply shocks.

The bank is constrained by accounting rules, Dimon said. "I would be putting up reserves. I can't. I am quite cautious about what's going to happen in credit."