Loan carry-overs in banking sector loan portfolios are high and could force many institutions to build up substantial reserves to cover future losses.

The Coronavirus Aid, Relief and Economic Security Act, passed at the end of March, has allowed financial institutions to avoid classifying loan changes linked to the COVID-19 pandemic as distressed debt restructurings and therefore require them to perform an impairment test. While smaller banks appear to have used carryovers the most, we estimate carryovers accounted for 7.2% of industry lending at the end of the first quarter, based on information provided by nearly 150 banks aggregated by analysts at Raymond James, Janney Montgomery Scott, Compass Point Research & Trading, and S&P Global Market Intelligence.

It seems likely that many of these deferred loans will transition to unrecorded status after the six-month forbearance period under the CARES Act ends, as borrowers opted for changes for a reason. Several banks such as Bank of America Corp. noted that 40% of borrowers taking advantage of deferrals continue to pay interest on loans, suggesting that not all loans will end up in default. However, other large institutions such as JPMorgan Chase & Co. note that 20% of credit card customers requesting forborne requested additional help.

Analysts at Janney Montgomery Scott estimate that 40% of loan deferrals could go into non-recognition after the forbearance period ends. Banks will likely cut back on loans that go into unfunded status. Keefe Bruyette & Woods analysts estimate carryforward losses could reach 10%.

In our analysis, we assumed that 30% of deferrals would become non-performing and then result in a loss given default of just under 55%. This assumption was based on losses suffered by banks between 2007 and 2009 and on a study by the Federal Deposit Insurance Corp. on losses given default on the assets of failed banks during the Great Recession. If that happened, losses on deferrals would reach $ 128 billion, or about 7.5% of the industry’s tangible ordinary equity at the end of the first quarter of 2020.

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We assumed that the carry-over and losses would be different for different asset groups. Listed bank disclosures show that small community banks have offered deferrals to their customers in the double digits. The level of abstention declines as banks grow larger and stands at just 3.20% among the largest banks in the country. However, loss given default has historically been lower among smaller institutions and has been estimated at just under 40%, leaving their potential loss content on a par with the large regional banks which have not. not used carryovers as often.

Reserve levels in large regional banks have more than covered the amount of potential losses on loan carry-overs on their books, while reserves are estimated at just under 60% of carry-overs in institutions with less than $ 1 billion. dollars in assets. But most small banks have yet to adopt the current expected credit loss model, which requires institutions to reserve for future losses throughout the life of their portfolios. The new accounting methodology resulted in a significant increase in reserves in the first quarter.

While deferral practices look quite different when comparing large and small banks, the experience across regions seems much more similar. Deferrals appear to be highest in the South West, with around 10.2% of deferred loans. The West and Northeast followed closely behind with 10.1% and 9.7% deferred loans, respectively. Banks in the Southwest could also experience the largest losses on carryforwards to equity, with potential losses equivalent to 13.0% of tangible ordinary equity in the first quarter.

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The magnitude of the losses will depend on the shape of the economic recovery and the underwriting practices of a given bank, but it seems difficult to argue that deferrals are likely to carry more risk than many other loans. The KBW analyst team also tracked the risk capital of the surge in deferrals by adding them to the numerator of the Texas ratio, which measures the risk of bank failure. Texas Historic Ratio compares a bank’s assets and loans that have not performed for 90 days or more due to its tangible equity and loan loss reserves. A ratio greater than 100 indicates a higher risk of default since the amount of assets at risk exceeds the capital and available reserves.

KBW’s modified Texas ratio adds deferrals to non-performing assets as they also put capital at risk. Given the large number of deferrals in the industry, especially among smaller institutions, Texas’ estimated and modified ratio exceeded 100% among banks with less than $ 1 billion in assets. Texas’ modified ratio for the industry aggregate was 48.7% in the first quarter.

Looking across regions, Texas’ modified ratio appears to be the highest in the West at 71.2%. The ratio was the lowest in the Midwest at 40.9%.

In the upcoming second quarter earnings season, banks are expected to offer more information on the amount of deferrals they have offered and the behavior of borrowers receiving relief, but the ultimate credit risk will not be. will probably be realized that later this year.

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For our latest outlook for the US banking industry, including credit quality, please Click here.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.

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Mark Lewis

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