Loan Growth Prompts Higher Provisions at Some Banks

A spike in loan-loss reserves is usually a bad sign, though the second quarter may have been an exception for several banks.

A number of lenders recorded bigger loan-loss provisions, compared to a quarter earlier, even as other credit metrics, such as net chargeoffs and nonperforming assets, have stabilized or improved. This could suggest that these banks have worked through crisis-era reserves and are now setting aside cash for future growth.

"There's little question the second quarter was good for banks that have reported so far," said Christopher McGratty, an analyst at Keefe, Bruyette & Woods.

"The full normalization from the credit cycle has occurred," he added. "If banks are going to continue to grow they're going to have to set aside for future credit losses. That's what we've been seeing."

Loan growth is the story of the second quarter for community banks that have reported so far. Total loans grew by an average of 6.5% compared to the first quarter and 14.2% from a year earlier, based on American Banker research of 200 banks with $40 billion or less in assets.

The growth has been stronger than expected, with 65% of banks beating their lending forecasts and about the same percentage beating earnings forecasts, according to a note published Monday by analysts at Keefe, Bruyette & Woods.

Credit metrics are stabilizing and, in some instances, improving. Net chargeoffs, on average, were relatively flat from the first quarter and down 43% from a year earlier at banks with $40 billion or less in assets. Nonperforming assets decreased 4% from the first quarter and 20% from a year earlier.

Most of those banks are continuing to reduce their provision expenses. The average provision fell 23% from the first quarter and 26% from a year earlier.

Still, a significant number of banks, including FirstMerit in Akron, Ohio; Fulton Financial in Lancaster, Pa.; and Lakeland Bancorp in Oak Ridge, N.J., increased their loan-loss provisions as loans increased and nonperforming assets decreased. And fewer banks released reserves than in previous quarters, analysts said. 

"Many banks weren't provisioning in 2012 and 2013 because they had done so much provisioning in 2008 and 2009 and were whittling down their reserves," said Mark Fitzgibbon, an analyst at Sandler O'Neill. "Banks have again started to see the need to provide for new loan growth."

Growth has been especially striking at healthier midsize banks. Loans rose 26% from a year earlier at Signature Financial in New York and 19% at Wintrust Financial in Chicago.

Other strong, if less dramatic, gains were reported by Synovus Financial in Columbus, Ga.; Associated Banc-Corp in Green Bay, Wis.; and Webster Financial in Waterbury, Conn. Commercial lending was the primary driver in each instance.

Executives at Wintrust, Synovus and Associated said they recorded bigger reserves in part to keep up with the growth. Webster, which has had credit-quality issues stemming from the downturn, recorded its second straight quarter where the provision exceeded net chargeoffs, indicating that loan growth is overtaking legacy credit issues, Fitzgibbon says.

A small handful of banks have rapidly expanded lending while continuing to release past reserves. U.S. Bancorp's loans increased by 8%, and it released about $25 million from its loan-loss allowance in the second quarter. Richard Davis, U.S. Bancorp's chairman and chief executive, told analysts during a conference call last week that a rise in the Minneapolis company's loan-loss reserve would be a sign of health.

"I'd love to be adding to loan losses, because the loan growth is so robust and we should prepare for years forward," he said. "So that, to me, won't be a bad outcome. But we are not there yet."
Some analysts are less optimistic, noting that higher reserves could stunt profit. Reserve releases have been an important short-term earnings boost in recent quarters, and a need for higher reserves could mean an end to that revenue stream.

Reserve releases made up about 30% of banks' pretax revenue before the financial crisis, but that figure has dwindled to the mid-single digits in recent quarters and will likely decline further, says Terry McEvoy, an analyst at Sterne Agee.

"This is a headwind to near-term earnings for the industry," McEvoy said. "The benefits of releasing reserves seem to have passed, and the acceleration of loan growth means there isa need to provision for new loans."

Massive loan growth also has a downside. The commercial loan growth in the second quarter came at the expense of net interest margins, which compressed slightly from a quarter earlier, to 3.70% at banks with $40 billion or less in assets.

Growth could also be coming at the expense of underwriting standards. The Office of the Comptroller of the Currency said last month that it had noticed more banks making exceptions for commercial borrowers. Banking analysts have also noted that the industry's coverage ratio, a measure of a bank's ability to withstand losses, is quite low by historical standards, though it has been rising.

Despite tighter margins and intensive competition, most analysts don't yet feel the industry has reached an underwriting danger zone. Most think current loan growth should be sustainable for the near future.

"It's not free to be aggressive on pricing," McGratty said. "Banks are willing to go down in rate to keep or grow their customer base, but when do we get to the point where it's so ridiculous that they are willing to walk away?"

Nonetheless, McGratty said he's generally optimistic about faster-growing banks, noting that while overaggressive lending may hurt down the line, losses are a ways off. "You're not going to see the bad credits show up for a long time," he said.

Meanwhile, publicly traded banks continue to see a strong incentive to push loans higher, despite possible long-term risks.

"Investors have been rewarding banks for loan growth," McEvoy said.

"It's appropriate to be cautious," McEvoy added. "But it's too early to say whether the weakening of credit standards will come back to bite the industry, or whether locking in the loans now will expose banks to interest-rate risk when the rates go up."