Saturday, June 4, 2011

A function of banks is to incur credit losses

Since the beginning of the credit crisis, a critical function of banks has been all but forgotten.  Not only are banks suppose to make loans and investments, but they are also suppose to incur losses when these loans and investments cease performing.  That is what loan loss reserves and capital are for!

When a bank makes a loan, as part of the underwriting process, it estimates how risky the borrower is.  A spread to cover the risk of the borrower is built into the interest rate charged to the borrower.  When the loan is funded, the bank takes a reserve against the loan based on the probability that the borrower will default.

Obviously, the bank does not make a loan to a borrower it expects to default.  However, the bank knows that some of its borrowers will default.  That is why it sets up a loan loss reserve.  If the defaults run higher than the reserve, the losses are absorbed by the shareholders.

However, since the start of the credit crisis, regulators have taken steps to prevent banks from fulfilling the critical function of absorbing losses.

A prime example of this is Greece.  For the last 2+ years, it has been well known that Greek debt, like the loans to Less Developed Countries in the mid-1980s, is not worth its par amount.

In a functioning banking system, banks would be effectively marking the loans to market by taking additional reserves as needed.  As a result, restructuring the Greek debt would be a non-event.  The loan loss reserve would decline.

In the current banking environment, the regulators are actively engaged in trying to prevent the restructuring of the Greek debt.


After 2+ years of near record profits, are banks not adequately reserved and capitalized to absorb the losses?  Or, have regulators forgotten that banks do take losses?

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