Tracking the Leading Indicators – Loan Loss Provisioning for Credit Card Banks
We are currently in a historically low and sustained credit loss environment for consumer credit cards in the U.S. market; but to what degree and for what duration is this sustainable?
To address the question of degree, common wisdom suggests credit cards are a cyclical business with a perpetual series of undulating ups and downs in credit losses. What’s different about the current cycle is the formidable impacts of several regulations. For example, the Durbin Act has increased financial institution focus on promoting credit cards for transactors and for everyday spend. Meanwhile, the introduction of several recent regulations, along with continual CFPB oversight, has reduced the ability for issuers to market to, originate, and profit from consumers currently residing in new to credit or credit challenged segments. We believe the above regulatory impacts and other factors have not only been a significant driver of the current low credit risk environment but potentially also a moderating factor for credit loss increases in future cycles.
To address the question of duration, we may be nearing a point of inflection marking the end of declining credit loss rates and the potential for stable or moderately rising credit loss rates. To analyze this question more closely, via SNL, we identified 18 financial institutions for which, as of 3Q 2014, managed consumer credit card loans were equal to or greater than 50% of such institutions’ total managed loans. Figure 1 shows the total provision for loan losses expense for these banks since 2005 as well as net charge-offs (i.e., gross charge-offs minus recoveries).
Figure 1: Loan Loss Provision Expense vs. Net Charge-Offs – annualized % of balances
During the period from 2005 to 2009, the amount of the provision was greater than net charge-offs, which would result in a net increase in the contra asset loan loss reserve (“LLR”) held on such banks’ balance sheets for each period equal to the provision minus net charge-offs. When banks incur provision expenses in excess of net charge-offs, this typically signifies a forecast of rising net charge-off rates.
Conversely, from 2010 to 1Q 2014, provision was less than net charge-offs, indicating an outlook for declining net charge-offs and resulting in net take downs of LLR. In 2Q 2014, provision equaled net charge-offs; and, in 3Q 2014, for the first time in nearly five years, provision was greater than net charge-offs for these banks. As such, we may be entering into a trough or a potential modest uptick in net charge-off rates in 2015.
To study the data a little closer, Figure 2 arrays a subset of these 18 banks with at least $1 billion in managed credit card loans over the same period with, for each bank, a calculation of each period’s provision expense minus net charge-offs. Figure 2 also shows the same point of inflection described above as, for 3Q 2014, the “Combined” line as upticked to greater than 0%.
Figure 2: Loan Loss Provision Expense minus Net Charge-Offs – annualized % of balances
(positive % = increase in loan loss reserve / negative % = reduction)
Another observation from Figure 2 would be the relative dispersion of banks around the Combined mean. Generally speaking, these banks were in a fairly tight pack in 2005 followed by many periods of more pronounced dispersion meaning a wide variation of provision expensing relative to net charge-offs across banks. More recently, banks were in a tighter pack in 2Q 2014 and particularly 3Q 2014, which had the lowest dispersion of any period on this graph. Although the notion of any rise in net charge-offs may be unwelcomed, a tight dispersion of banks, indicating a high degree of harmonization and certainty of outlook across issuers, likely portends a very moderate and controlled increase.
For more information, please contact Frank Martien, Partner, specializing in Bankcard Issuing, email@example.com.
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