Tuesday, July 7, 2009

What’s next for US banks

Two different kinds of accounting—fair value and hold to maturity—have created two different kinds of crises. One is almost over. The other is only beginning.

McKinsey Quarterly

JUNE 2009 • Lowell Bryan and Toos Daruvala

Source: Financial Services Practice

Financial Services, Banking article, What’s next for US banks

… How close are we to the restoration of a strong and profitable banking and securities industry that is capable of providing the US economy with the credit it needs to grow?

The good news is that we have probably turned a corner in the credit securities crisis … But the contours of a broader resolution of the crisis will remain fuzzy for some time to come. That’s because what many have been regarding as a single credit crisis is in reality the tale of two closely related but different crises, each with its own pace, duration, and demands on banks to rediscover operational discipline in a harsh economic and regulatory environment.

Twin crises

The first credit crisis was centered in the securities markets and initially manifested itself in the subprime and mortgage-backed securities markets. Because of the fair-value accounting that broker–dealers and investment companies use to mark assets to current market expectations, these firms began to suffer deep losses on mortgage-backed securities long before large volumes of loans started to default. …

The good news is that we appear to be seeing the end of this credit securities crisis. That is in part due to the clarity provided by the stress test exercise and the ongoing commitment on the part of government not to allow a large-scale bank failure. The other credit crisis is a commercial-bank lending crisis. …[It] involves a broader array of lending, including commercial real-estate loans, credit card loans, auto loans, and leveraged/high-yield loans, all of which are now going bad because of the economic downturn. The bulk of these loans are subject to hold-to-maturity accounting, which, in contrast to fair-market accounting, typically does not recognize losses until the loans default. The bad news is that this crisis is still in its early stages and may take two years or more to work through the credit losses from these loans.…

It might seem odd that accounting methodologies can make such a big difference. At the end of the day, what counts is the net present value of the cash flows from each asset, but those are unknowable until after a debt is repaid. Fair-value accounting, based on mark-to-market principles, immediately discounts assets when the expectation of a default arises and ability to trade the assets declines. Fair-value therefore makes the holder of the assets look worse, sooner. Hold-to-maturity accounting works in reverse and makes the holder look better for a longer time.

First-quarter 2009 earnings

Many of the largest banks reported a return to profitability in the first quarter of 2009. The comfort this provided to markets is not necessarily misplaced. …

An analysis of these results shows that quarterly noninterest revenue for corporate- and investment-banking activities (that is, largely broker–dealer operations) increased by a surprisingly large $26.3 billion from the prior year …. Fair-value accounting losses depressed 2008 results but in 2009 were replaced by fair-value gains. Large additional trading profits were made possible by arbitrage and other trading opportunities that became available as market conditions improved.

While the worst may be over for the broker–dealer sector, first-quarter 2009 results tell a different story for commercial-banking activities at the same major banks. These banks took $38 billion in loan-loss provisions in the first quarter, $16 billion more than in the 2008 period. Most of this increase—$12 billion—was from retail-banking and credit card credits. …

This merits concern because loan provisioning under hold-to-maturity accounting is a lagging indicator of future loan losses. … When loan-loss provisions start rising rapidly, it is likely that more losses lie ahead.

Loan losses to come

While 2008 was the year for taking losses on broker–dealers, this year and next will be the years for taking losses on assets subject to hold-to-maturity accounting. These are the losses that show up in stress tests, in which regulators make assumptions about how the economy will perform and calculate the resulting loan losses under various economic outcomes. …

McKinsey research estimates that total credit losses on US-originated debt from mid-2007 through the end of 2010 will probably be in the range of $2.5 trillion to $3 trillion, given the severity of the current recession … Some $1 trillion of these losses has already been realized. Since US banks hold about half of US-originated debt, the US banking and securities industry will incur about $750 billion to $1 trillion … of projected losses on this debt, which includes residential mortgages, commercial mortgages, credit card losses, and high-yield/leveraged debt. …

Since the middle of 2007, the US banking and securities industry has absorbed some $490 billion of losses, or $80 billion per quarter … If the industry incurs additional losses of $1 trillion in 2009 and 2010, the losses will be about $125 billion a quarter. … Importantly, many of these losses will be concentrated in the banks that the stress tests revealed to be undercapitalized….

Grading the stress tests

Stress testing may have set the stage for restoring the health of individual institutions because it has provided the financial markets with information on the quality of each individual institution’s loan portfolio. …

The tests also marked a turning point because they provided much greater clarity regarding how the US government will handle troubled institutions in the future. … The government is clearly prepared to use whatever combination of funding support, guarantees, and capital injections are required to ensure that any future resolution of troubled financial institutions will be orderly.

Restoring earnings strength

While the stress tests have focused on capital adequacy, the only real way for an institution to become strong enough to stand on its own feet is through its ability to earn profits. …

The challenge for many adequately capitalized banks is that they will find it difficult to generate enough income to cover loan-loss provisions over the next two years. …

To meet this earnings challenge, well-capitalized and adequately capitalized banks must play both defense and offense. In terms of defense, investing in building collection and workout skills is essential. …

It is also essential for banks and securities firms to begin reducing operating expenses more programmatically. …[The] 19 stress-tested institutions have actually increased annual operating expenses by 32 percent since 2006…. Many banks need to target reductions in noninterest expenses of 20 percent or more from 2008 levels.

Banks with broker–dealers should have an abundance of opportunities as the markets continue to thaw. The pent-up demand for credit securities issuance, acquisitions, and spin-offs is considerable. Moreover, trading opportunities should be numerous for strong counterparties.

Challenges ahead

… Not only has the economic shock thrown financial markets and industry structures into flux, but the process of saving the banking and securities industry has transformed the nation’s social contract with the industry. The entire industry is now dependent on government support of all kinds, ranging from low-cost funding (courtesy of the Federal Reserve), to debt guarantees, asset guarantees, and capital injections.

There is no clear path to restoring the industry to independence from the US government. Major changes in regulation are coming, and the industry is going to be subject to more government involvement and oversight than it would like for a long, long time. Against that backdrop, stress testing has removed much of the generalized fear that painted all institutions with the same brush. It has also removed the uncertainty related to how the US government is going to treat individual institutions. But it will remain for the industry’s leaders to put in place the operational efficiencies and discipline that may determine when—and how—the credit crisis is finally resolved.

About the Authors

Lowell Bryan and Toos Daruvala are directors in McKinsey’s New York office.

The authors would like to acknowledge the contributions of Kevin Buehler, Chris Mazingo, Kazuhiro Ninomiya, and Hamid Samandari to this article.

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