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Are Bank Reserves Sufficient to Cover Bad Loans?

Daily Policy Digest

Economic Issues

Tuesday, November 27, 2001

The pool of money banks set aside to cover defaults -- called the "loan loss reserve" -- may not be sufficient to handle soaring defaults and slow payments, according to a study of 38 large banks by UBS Warburg's equity research team.

  • So far in 2001, banks have kept reserves at 2000 levels -- despite the worsening economy and rising rates of charge-offs.
  • Even before Sept. 11, charge-offs of bad loans had risen 40 percent from the second quarter of 2000 to the second quarter of 2001.
  • The UBS analysts say banks need to boost their reserves by a combined 40 percent -- which would shave $6.4 billion from pretax earnings.
  • Banks have an incentive to under-reserve, because additions to the reserve pool come out of net income.
But experts say the shortfall does not mean that banks are financially unsound. In fact, they say that banks are actually better capitalized now than they were in the early 1990s at the time of the last recession.

Source: Margaret Popper, "Economic Trends: Are Banks Ready for Deadbeats?" Business Week, November 26, 2001.

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