NEW YORK - Banking companies are not adequately prepared to absorb the risk of contingent liabilities, Michael L. Mayo, a banking analyst at Prudential Securities, has written in a report.
In the report, published Monday, Mr. Mayo said loan-loss reserves are inadequate to cover a potential deterioration in credit quality due to off-balance-sheet credit exposure.
Earnings could decline by as much as 22% if banking companies decide to beef up their reserves to 2% of problem loans, which is a level Mr. Mayo said is necessary to cover the risks. Taking contingent liabilities into account, the banking industry's reported 1.62% reserve ratio would be 1.34%. Even if companies increase their reserves back to 1.62%, profits could fall by 9%, he wrote.
Mr. Mayo said current reserve calculations fail to capture the potential threat, because borrowers might take advantage of unused credit lines, and he used Xerox Corp. as an example.
Banks, he wrote, "are on the hook to lend money in the future in return for an up-front fee. In today's softer economy, this issue takes on greater importance."