Breakingviews – The Bad Debt Puzzle Has A Simple Answer: Consumer Credit

MasterCard credit cards can be seen in this illustrative photograph taken in London on December 8, 2010.

LONDON (Reuters Breakingviews) – Banks’ bad debt charges in the event of a pandemic paint a confusing picture. JPMorgan CEO Jamie Dimon set aside around $ 8 billion for missed loans in the first quarter, which equates to more than 3% of the US group’s loans on an annualized basis. In contrast, Deutsche Bank’s Christian Sewing increased the German lender’s bad debt reserves by € 500 million, or just 0.4% of total loans.

One interpretation is that Deutsche, Royal Bank of Scotland, UBS and other loan loss laggards are leisurely in the face of the coronavirus crisis, or are less able to prepare for the worst. However, dig deeper into balance sheets and a simpler explanation is that the main source of concern is exposure to consumer credit.

It is difficult to compare the loan books of lenders. Most of them intermittently report exposures by sector and region, but do not break down loans by country, counterparty or type of collateral. Two lenders with seemingly similar exposures to airlines and mortgages, for example, might actually have very different risk profiles. It is therefore difficult to judge whether the provisions for bad debts adequately cover possible future losses. Accounting rules also vary. US banks are supposed to provision for expected losses over the life of a loan, while their European counterparts are only required to do so when credit quality deteriorates. Governments have also responded to the coronavirus pandemic in different ways. Wage guarantee systems, like the one adopted in Britain, should help people keep their jobs and therefore pay their bills better. Meanwhile, unemployment has skyrocketed in America. This is important because banks must implicitly consider the effectiveness of government responses when incorporating economic forecasts into their loan loss models.

However, it is possible to make some sense of the jumble of loan loss figures. The first step is to look at each bank’s total bad debt allowance stock, not just the extra amount it set aside in the last quarter. This is important because some lenders, like Spain’s Banco Santander, have historically allocated more of their profits to possible losses, giving them a bigger buffer before the crisis.

The second step is to focus on consumer credit, which was responsible for some of the biggest bad debt charges at lenders like JPMorgan and Barclays. US banks report total credit card loans outstanding each quarter. For Europeans like BNP Paribas and Santander, it’s a bit trickier. The outstanding loans from the French consumer-focused bank’s personal finance division are a decent approximation, as is the stock of consumer loans from the Spanish lender. However, these figures include both unsecured and secured debt, such as car financing.

The analysis reveals a clear trend. The higher a bank’s concentration on unsecured consumer credit, the higher its total provisions as a percentage of total loans (see chart). There is also a strong correlation between banks’ consumer credit exposures and the size of their bad debt charges in the first quarter. Lenders appear to be betting that coronavirus-related loan losses will be concentrated on consumer credit. One explanation that UBS, Credit Suisse and Deutsche have put aside relatively little so far is that they barely dabble in this industry.

The thinking of the banks is logical. A troubled borrower is more likely to stop paying interest on an unsecured loan, like a credit card, than to risk losing their home by skipping mortgage payments. Banks also have less to recover from a default when the loan is unsecured.

Yet the risks of bad debt could easily extend beyond consumer credit. Commercial real estate could be the subject of a brutal calculation if white collar workers in major cities decide not to return to the office when the lockdowns are lifted. Governments will at some point have to reduce their stimulus measures, potentially leaving over-indebted small and medium-sized businesses vulnerable. Mass unemployment would lead to an increase in mortgage defaults.

The financial crisis of 2008 is also revealing. While few banks have lent directly to subprime US mortgage borrowers, many have ended up suffering huge losses on the securities backed by those loans. The solution to the bad debts puzzle of banks in the first quarter is proving to be quite simple. The next chapter can be anything but.

Breakingviews

Reuters Breakingviews is the world’s leading source for financial information on agenda making. As the Reuters brand for financial commentary, we dissect big business and economic stories from around the world every day. A global team of around 30 correspondents in New York, London, Hong Kong and other major cities provide real-time expert analysis.

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