Banks: Energy Losses Now, Not Later

Some big banks have decided to take their expected losses in energy loans now

In recent weeks, oil prices have inched upward, and seldom have markets and investors felt good about that.

After the precipitous, steady slip in prices over the past year, the oil-and-gas industry drooped toward turmoil, and banks braced themselves at the start of 2016 for a rough year of loan losses from lending to hundreds of companies that have ties in some way to slumping prices of oil.

Once prices dipped below $30/barrel and companies started to disclose sour results and whined that losses could continue through the year and perhaps into the next, bank shareholders and analysts began to react. They tapped their calculators and ran their computer models to determine how many billions banks will lose in the next few years.

Many dumped bank shares and pushed prices downward. JPMorgan Chase share prices in the mid-60's had slid suddenly into the mid-50's, at least until the market could learn the gory details about what's vulnerable in their portfolios of energy loans.  Pessimistic equity markets in the midst of a wild, volatile first quarter could easily have inferred that billions in bank loan losses will be sufficient to trigger the next Great Recession. 

In the past month, banks, likely with some urging from regulators, jumped ahead of the guessing games and decided to compute their expected losses. 

(For banks, "expected losses" are a function of probabilities of default, which in the industry certainly rise when prices are declining. They are also a function of recovery rates after default.  Factors such as collateral, third-party support, guarantees, loan tenor and loan seniority increase the likelihood of recovery.)

With Wells Fargo and JPMorgan taking the lead, big banks have decided to

(a) report details of the total amount of loans they have in the energy sector,

(b) act conservatively and reserve for possible losses at amounts far more than they actually expect to lose and

(c) remind market watchers of the huge capital bases they now maintain (thanks, in part, to new regulation) to act as a comfortable cushion against actual losses in the years to come.

They counted up their energy-related exposures, including those to companies that supply the industry and build its equipment and even including amounts that have not yet been borrowed under committed revolving-credit arrangements.  They tallied the amounts that have collateral.  And they declared they are taking the bulk of expected losses now. 

JPMorgan increased energy-related loan losses by $500 million; Wells Fargo took  provisions of $1 billion.  (The biggest banks are reporting total exposures in the tens of billions, not the hundreds of billions.)

They helped prove such conservative gestures won't damage the viability of big banks with capital bases that exceed $150 billion (as both JPMorgan and Wells Fargo possess).  Energy-industry exposures still comprise less than 10% of all loan exposures. The expected losses are still less than 10% of total bank equity capital.

Regulators, for sure, likely applauded these moves or might have coerced banks to do the same if they banks had sat still. Post-crisis regulators are intimately involved and influencing behavior.  They frightened many big banks last year with their exhaustive, comprehensive stress tests and weren't reluctant to report who passed, who failed, and who received an incomplete assessment. This year, regulators could choose to crunch numbers and come back to report which banks they believe couldn't pass a new stress test tied to a prolonged slump in oil prices.

The loan-loss gestures of JPMorgan and Wells Fargo, however, are isolated and don't necessarily account for what has haunted banks to no end in the past decade:  correlation.  What happens in one loan sector (in one industry) might cause horrors in other sectors.  Problems in the oil industry might lead to problems in other industries--equipment manufacturing, transportation, or even consumer products in the long term. (To its credit, in its compilation of oil-industry exposures, Wells Fargo even reports consumer loans to employees in the industry.)

The exercise is far from over. Banks will continue to watch and worry about oil-and-gas exposures and review portfolios almost daily. Many will have already initiated steps to reduce risks in other ways: 

a) hedging by purchasing credit-default swaps (before they become too expensive),

b) arranging to reduce loan outstandings while they can,

c) cancelling lines of credit where they can legally, selling loans to other institutions that have the risk appetite or like the loan returns (given the high risks), 

d) requesting more collateral,

e) renegotiating terms, and

f) postponing new business at least until oil prices to trickle back up to a certain level.

Some are revamping energy-banking units to focus, as well, on other energy projects and related companies--sustainable and green energy, wind and solar projects, natural gas, etc.

The most experienced bankers understand how the oil industry is intermittently volatile and how booms, busts and oil cycles occur with near certainty. 

Tracy Williams

See also:

CFN: The Collapse of Oil Prices: Painful for Banks? 2016
CFN:  Banks' ROE's:  Stuck at 10%?
CFN: When Does a Bank Have Enough Capital? 2015
CFN: Credit Suissie's Big Move, 2015