Small loan losses can wipe out banks

April 30th, 2009

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This week, Australian banks are confessing to profit downgrades. One of the chief reasons for reduced profit is the rise of bad debts. Also, banks are setting aside greater provisions for bad debts. That is, as we wrote before in Is a bank safe if it makes good profits?,

… banks will guess how much of its loans will default or be delinquent and apportion a small fraction of them as an expense. But until debt defaults really happen, a guess is just a guess.

Now, as you read the mainstream media, you may see positive spin being painted for the bad debt provisions by comparing their ‘miniscule’ size with the size of the entire loan portfolio. For example: “$1 billion of provisions for bad debt is only 1% of the entire loan portfolio.”

Well, small size (of bad debt provisions) can be very deceiving! Why?

Remember the concept of capital ratio that we introduced in Introduction to banking corporate accounting? Let’s say a bank is leveraged 25 times, it means they have a capital ratio of 4%. In this case, if 1% of their loans go bad, 25% of their equity are wiped out. If 4% of their loans go bad, the bank is completely wiped out and is insolvent.

Australian banks are more leveraged than their overseas peers, according to Brain Johnson, the former bank analyst of JP Morgan (see How safe are Australian banks?). So, a small proportion of loans going bad can have a more than proportionate impact on the bank’s balance sheet due to leverage.

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