WASHINGTON - The banking industry's eight-year run of record earnings is threatened this year as declining credit quality, reflected most prominently in the pending Shared National Credit Review, forces banks to divert earnings into loan-loss reserve accounts.
"This is the year that banks start adding to the reserve," said Lawrence W. Cohn, director of research at Ryan, Beck & Co. of Livingston, N.J. "That will have a fairly adverse impact on earnings." The industry's average reserves are at a 13-year low of $1.68 for every $100 of loans outstanding, the Federal Deposit Insurance Corp. announced Monday.
Loan-loss reserves are driven in large part by the Shared National Credit Review, which takes place every May and June as bank examiners assess the quality of every loan larger than $20 million that is shared by more than three banks.
This year's review involves more than $1.9 trillion of loans led by 175 banks and shared with 800 participating banks.
Though the government has been using the program to gauge credit quality since 1977, last year was the first in which regulators publicly detailed their findings: Troubled loans increased 70% last year, to $37.4 billion. The jump was steep, but it represented just 2% of the $1.83 trillion of loans reviewed.
The results of this year's review will be out this fall.
"I think the loan-loss reserve has gone about as [low] as it can, given the level of risk in the system," Deputy Comptroller for Credit Risk David D. Gibbons said this month. This week he reiterated his concern. "You can't have the amazing credit quality we've seen in recent years forever."
Early-warning signs of the current state of large syndicated credits came from Wachovia Corp. and Unionbancal Corp. Last week both said troubled syndicated loans required them to raise their reserves, which would take a bite out of second-quarter earnings.
During a conference call last week, Union Bank vice chairman Robert Walker mentioned the shared credit review. Though Mr. Walker was optimistic about the regulators' grading of credits his bank had led, he conceded, "In this environment, when in doubt, it gets the lower grade."
Mr. Gibbons declined to comment on preliminary results of the 2000 review but said common sense suggests the level of classified loans will rise again.
"Just looking at what is happening with bond default rates and the increase of nonperforming commercial and industrial loans throughout the last several quarters, I would expect there to be more classified credits," he said in an interview Tuesday.
Under the program, the bank that led a particular syndicated loan is examined, and whatever grade is assigned is shared by all the participating banks. There are three adverse ratings: substandard, doubtful, and loss. Loans may also be designated as "special mention," meaning examiners see potential weakness.
In the current review, regulators are focusing on leveraged finance, an increasingly large segment of the syndicated loan market. The percentage of leveraged transactions - those in which the amount of the loan is more than 3.5 times the collateral pledged - topped 35% this year, compared with 7.2% in 1993.
Leveraged transactions are particularly sensitive to rising interest rates.
"In the credits that have more leverage in them, there is going to be some impact from the Federal Reserve raising interest rates 175 basis points over the last 12 months," said Allen W. Sanborn, president of Robert Morris Associates, the national trade group for commercial lenders. "Anecdotally, we're hearing more stories about borrowers not meeting their plans even in this relatively strong economy."
One subset of the leveraged finance market that especially worries regulators is loans made against expected cash flow rather than hard collateral such as inventories. Regulators call these "enterprise-value" loans; industry sources term them "air-ball loans."
Health-care-related credits and loans financing subprime lenders are also under regulatory scrutiny, according to bankers. Though few problems have emerged, regulators are keeping an eye on the boom in commercial real estate lending.
But Richard Spillenkothen, director of bank supervision at the Federal Reserve Board, said Tuesday that examiners are not targeting specific kinds of loans in this round of the shared review.
"We were more interested in trying to focus on the way that institutions manage their risk and conduct their stress testing, to make sure they maintain rigorous pricing procedures and that they don't assume that rapid growth and revenues will continue indefinitely," he said.
Not all observers see the decline in credit quality as a major problem.
"The historic low in nonperforming loans is at an end. Is it a time to be more vigilant? Absolutely," American Bankers Association chief economist Jim Chessen said. "But the year 2000 will be a very, very good year for banking."
Ironically, much of the recent hand-wringing over credit quality was triggered by Wachovia's addition of $200 million to its loan-loss reserves to cover an expected 30% increase in nonperforming loans. If traditionally conservative Wachovia could take such a hit, analysts asked, what does that mean for the rest of the industry?
By itself, not much, some observers said.
"This is a company that has a long history of pristine credit quality that has over time been able to be very careful in choosing who it does business with," said Mr. Cohn of Ryan Beck. "It has, to some extent, lost that capacity in this cycle; the traditional Wachovia customer got a little more price-sensitive than they used to be and got substantially more used to dealing in the capital markets."
The result, he said, is that the bank began serving somewhat lower-quality customers. The increase in loan-loss reserves is not a sign of the traditional Wachovia customer becoming a greater credit risk; it is a sign of Wachovia's changing customer base, he said.
Wachovia's overall credit quality "is moving toward the average in the industry," Mr. Cohn said.
Will 2000 be the year that banks stop breaking earnings records?
"It is possible, but I think it depends on what comes out of the Shared National Credit Review," Mr. Spillenkothen said. "It is hard to say because a lot depends on the future force of the economy, what happens in other sectors, and banks' own lending practices."