After boosting reserves by $400 billion in the first quarter to shore up against potential losses from the coronavirus pandemic, U.S. banks have already raised that amount by another $900 billion, according to the latest Federal Reserve data.
That larger buffer may be needed, according to a new CoStar analysis. As the crisis took hold in March, hundreds of banks appeared to lack the capital to weather a severe downturn.
“What we can see from the analysis is the direction coronavirus stress is heading,” said John Vecchione, vice president of CoStar Risk Analytics. “The longer the coronavirus impact lingers and the deeper it cuts into the economy, the worse it could get.”
Banks collectively entered the crisis with strong balance sheets and, as a group, are generally expected to show resilience to the economic fallout. At the same time, they are not immune to the longer-term economic implications, according to a report from S&P Global, the New York financial information firm.
The $2 trillion federal coronavirus stimulus, as well as multiple liquidity efforts the Fed has launched since the outbreak, should help U.S. financial institutions. However, banks are likely to experience rising loan modifications as well as significantly higher charge-offs, according to S&P.
On March 15, the Fed for the first time said it was reducing reserve requirements to $0, allowing banks to tap into their reserves for lending. The Fed also encouraged banks to borrow from its discount window to meet their liquidity needs. Despite the guidance, the latest Fed data shows banks are actually growing their reserves.
As of April 22, the latest data available, banks held $3.01 trillion in total reserve balances plus vault cash. Those reserves are protecting more than $20.1 trillion in assets from loan, lease and other asset losses, as well as deposit withdrawals. The reserve amount totals about 14.5% of assets. That number is up from 10.1% as of March 2019.
Through the end of the first quarter, the amount of reserves set aside specifically for loan and lease losses was growing at an annualized rate of 23.4%, compared to an average of 1.2% for 2019, according to Fed data.
Still, not all banks may be in a position to withstand the wave of defaults and losses resulting from the pressure COVID-19 is putting on the U.S. financial system. Whether those capital buffers are robust enough to get individual banks through the public health crisis is the question on the minds of many, according to Vecchione.
To get a glimpse of the answer, CoStar Risk Analytics stress-tested the year-end 2019 financial statement for one bank with $10 billion in assets. It then randomly selected loans using Trepp’s commercial mortgage-backed loan universe and composed a hypothetical but comparable $3.1 billion commercial real estate loan portfolio. New York-based Trepp provides data, analytics and technology to the securities and investment management industries and worked with CoStar Risk Analytics in preparing the analysis.
The commercial real estate loan portfolio was then run through various coronavirus impact scenarios.
“The first scenario was a base-case scenario for the period prior to the COVID-19 outbreak. The other three are our COVID scenarios, with increasing levels of severity,” said Xiaojing Li, managing director of CoStar Risk Analytics, who developed the stress-testing scenarios.
Prior to the COVID-19 outbreak, the bank in the analysis was well capitalized. Its commercial real estate loans carried a capital reserve ratio of 6.6% prior to COVID-19, which is above the 6% minimum Tier 1 capital ratio threshold required by banking regulators. Tier 1capital is used to describe the capital adequacy of a bank and refers to core capital that includes equity capital and disclosed reserves.
The portfolio was assigned a risk weight of 83%. The lower the risk weight of bank assets, the less amount of money banks must hold in reserve should the assets go into default.
“From the mild downside to the severe downside of our three COVID-19 scenarios, risk weight goes up to 95%, 104% and all the way up to 120%, respectively,” Li said. “In this case study, this bank just reached its breaking point under our COVID-19 severe downside scenario.”
Similar CoStar Risk Analytics stress testing was then applied to more than 5,000 banks based on year-end 2019 numbers.
The results show that the ratio of Tier 1 capital to risk-weighted assets of eight banks was already less than 6%, the minimum required by banking supervisors.
As the projected losses increase three, four and five times under the COVID-19 scenarios, the number of banks with Tier 1 capital ratios less than 6% grows to 30, 110 and 358, respectively. The number suffering under the most serious scenario still seems to fall short of the pain inflicted during the Great Recession, when 489 banks failed between 2008 and 2013.
Whether that coronavirus-stress breaking point will apply across the board for all banks is not clear, especially as many have taken action to boost their reserves.
Also, Fed, Treasury Department and congressional actions to date are designed to stem such banking damage. The stimulus provided banks optional temporary relief from the accounting impact of expected credit losses until the time the national emergency associated with the pandemic ends or Dec. 31, whichever comes first.
“There are still many unknowns and uncertainties as to how many banks could be stretched to their breaking points,” Li said.
It depends on an individual bank’s performance and whether that performance being driven by certain types of lending such as credit cards, single-family homes or commercial real estate. It also depends on how much longer the crisis will last.
However, the stress-testing scenario can be a reality check on current bank conditions, she said.