Bank Investing

CHAPTER 4Credit

“But Credit being nothing but the expectation of Money within some limited time, Money must be had or Credit will fail.”

—John Locke 1632–1704

This chapter delves a little deeper on the topic of credit. We had previously discussed allowances for credit losses (also called loan loss reserves) in Chapter 2.

AREN'T HIGHER RESERVES BETTER?

Not really. Reserves need to be appropriate. While a low level of reserves may very well be inadequate and a high level of reserves may indicate conservatism, it is not always the case. Banks that have been acquisitive may have reserves that appear understated. This is because historically, the loan loss reserves of the acquired bank do not carry over, and the target's loans are brought onto the acquiror's balance sheet at fair value, inclusive of credit marks. Prospectively, this has changed under the new CECL accounting standards (colloquially pronounced “see-sul”) which we dive into in Chapter 8.

There was a time when not many banks set up reserve accounts, and there was also a time when banks were told by regulators that their reserve levels were too high! (Exhibit 4.1) It would be instructive to take a short detour through history to see how we got here.

Prior to 1947, most banks deducted loan losses directly from earnings on the income statement and retained earnings from the balance sheet when the loan was charged off.

As can be seen in Exhibit 4.1, the percentage of banks with a reserve account went up significantly ...