Ethan Riley
Banks can write off losses in several ways, including loan write-offs and the creation of provisions for loan losses. A loan write-off occurs when a loan is deemed irrecoverable and worthless, while provisions for loan losses involve setting aside funds to cover potential losses. Additionally, banks can sell bad mortgage assets to governments and write off the losses, impacting their tax liabilities. The treatment of loan losses varies across countries, with some adopting the charge-off method, which may restrict tax deductions for loan losses. The distinction between general and specific provisions for loan losses can also be fuzzy in banking practices. Ultimately, banks have various strategies for managing and writing off losses, with tax implications being a key consideration.
| Characteristics | Values |
|---|---|
| Reasons for write-offs | To remove toxic loans from their balance sheets and reduce their overall tax liability |
| Accounting methods | Loan write-offs and creation of provisions for loan losses (or bad and doubtful debts provisions) |
| Write-off methods | Direct write-off method, charge-off method |
| Country-specific practices | In Australia, Net write-offs are the sum of 4, 5 and 6; current losses are the sum of 1, 3, 5 and 6 |
| Tax treatment | Countries that employ the charge-off method disallow the tax deductibility of provisions |
| Regulatory standards | Regulatory financial standards provide different means of recognizing loan losses |
| Restrictions on write-offs | Requirement to exhaust all legal means of collection before a loan is written off |
| Impact on profit and loss | Write-offs of loans with no prospect of recovery impact the profit and loss account |
| Example scenario | A bank writes off $8,000 worth of loan defaults and takes an additional $3,000 as an expense |
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What You'll Learn
Banks' accounting practices and classification of securities
Banks employ various accounting practices to manage their financial operations and comply with regulatory requirements. One important aspect of bank accounting is the classification and treatment of securities. Securities are financial instruments that represent ownership or creditor relationships and are commonly traded in public and private markets. They encompass a wide range of investments, including stocks, bonds, investment contracts, notes, and derivatives.
One key accounting practice related to securities is their classification. Securities can be classified into various types, including debt securities and equity securities. Debt securities represent borrowed money and stipulate terms such as loan size, interest rates, and maturity dates. Examples include government and corporate bonds, certificates of deposit (CDs), and collateralized debt obligations (CDOs). On the other hand, equity securities grant holders some control over the company and voting rights. They include stocks, preference shares, and convertible bonds.
Banks also need to manage their investment portfolios, which include various securities. The Office of the Comptroller of the Currency (OCC) provides guidance on the classification of investment securities. For instance, the OCC has issued standards for assessing the creditworthiness of securities instead of relying solely on credit ratings. This helps banks determine whether a security is ""investment grade"" when evaluating credit risk in their portfolios.
Additionally, banks must address credit risks associated with their investment portfolios. The OCC offers guidance on safekeeping arrangements to mitigate potential credit risks when assets are held by third parties. Furthermore, banks need to be cautious about unsafe investment practices, especially when investing in securities during periods of low-interest rates, as this can impact future earnings and capital.
In summary, banks follow specific accounting practices and guidelines for the classification and management of securities. They must navigate credit risks, assess creditworthiness, and comply with regulations to ensure the sound management of their investment portfolios.
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Banks' response to losses
Banks' responses to losses can vary, but typically they will attempt to minimise the impact on their operations and financial health. Here are some strategies banks may employ to deal with losses:
Reclassification of Assets
In some cases, banks may reclassify their assets to avoid writing down their value. For example, they may label certain securities as "hold to maturity" (HTM), indicating their intention to hold the securities until maturity and cash them out at full value. This allows them to avoid regularly updating the asset prices as interest rates fluctuate, potentially hiding significant losses.
Lending and Asset Holdings Adjustments
Traditionally, banks respond to losses by pulling back on lending and reducing their total asset holdings. They may also adjust their lending practices by increasing interest rates and tightening standards for lending. This can lead to a reduction in corporate lending and a shift towards less risky securities.
Regulatory Intervention
When banks face significant losses, regulators may step in to take corrective action. This could involve the bank being forced to raise new capital, seek a merger partner, or even face closure by the relevant regulatory body. These actions aim to protect depositors and maintain the stability of the financial system.
Interest Rate Risk Management
Banks may attempt to minimise interest rate risk by strategically classifying their securities holdings. By classifying securities as "held-to-maturity," they can avoid immediate concerns about valuation changes affecting their regulatory capital ratios. However, this may only be a temporary solution, as rising interest rates can still erode the market value of their assets over time.
Cost Passing
In response to losses, banks may pass on their increased funding costs to businesses and consumers. Higher loan rates can help banks recover their losses, but they may also curtail investment demand and reduce economic activity. This strategy must balance the need to recover losses with the potential impact on the bank's reputation and customer trust.
It is important to note that the effectiveness of these strategies may depend on various factors, including the size of the bank, the nature of its losses, and the broader economic context.
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Unrealised losses and their impact on investor perception
Banks may be able to hide or minimise losses by taking advantage of accounting practices. For example, in the US, banks can classify securities as either "held-to-maturity" or "available-for-sale". By classifying securities as "held-to-maturity", banks do not need to update the asset prices as interest rates fluctuate. This means that banks can avoid recognising losses on securities, as they are considered to be held-to-maturity and will be cashed out for the full value at maturity.
However, the collapse of Silicon Valley Bank in March 2023 highlighted the fact that banks are holding substantial unrealised losses. This has led to investors perceiving banks as riskier, and it is likely that debt and equity investors will demand larger risk premia, increasing bank funding costs. This, in turn, will likely be passed on to consumers through higher loan rates, reducing economic activity.
An unrealised loss is a "paper" loss that occurs when the price of an investment declines below its purchase price, but the investment has not yet been sold. These losses are theoretical and only become realised when the investment is sold. For tax purposes, a loss needs to be realised before it can be used to offset capital gains. From an investor's perspective, unrealised losses can impact their net worth and investment performance, as they reflect a drop in net worth and struggling returns.
The psychological impact of holding unrealised losses is often different from that of holding gains. Investors may hope for a rebound in the underlying asset and may even take on additional risk in hopes of recouping their paper losses. This is known as the disposition effect, an extension of the behavioural economics concept of loss aversion.
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How banks cope with unexpected losses
Banks can suffer unexpected losses for a variety of reasons, including economic downturns, unexpected market shifts, and aggressive growth strategies. To cope with these losses, banks employ a range of strategies to protect their financial health and maintain stability.
Firstly, banks maintain capital to safeguard against unexpected losses. This includes economic capital, which is decided internally, and regulatory capital, which is mandated by external regulators. Holding capital helps banks absorb losses without immediately threatening their solvency.
When faced with unexpected losses, banks may also adjust their lending practices and asset holdings. For example, following the oil price decline in 2014, banks involved with oil and gas producers cut back on lending to this sector while expanding lending and asset holdings in less risky securities. This shift towards less risky investments helps banks reduce their exposure to further losses and stabilise their balance sheets.
Additionally, banks may reclassify their assets to avoid writing down their value. For instance, by classifying securities as "hold to maturity", banks can avoid regularly updating their prices as interest rates fluctuate, potentially hiding losses.
In response to unexpected losses, banks may also seek support from government bodies and regulators. During periods of widespread financial instability, government intervention can shore up confidence in the banking system and prevent systemic failure. This may include shared loss agreements, where the Federal Deposit Insurance Corporation (FDIC) absorbs a portion of the losses on specified assets of a failed bank.
Finally, banks can also raise interest rates and tighten lending standards to cope with unexpected losses. This allows them to increase revenue and be more selective about their borrowers, reducing the risk of further losses.
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Regulatory action to address bank losses
Since 1991, Congress has required federal banking regulators to take prompt corrective action (PCA) to identify and promptly address capital deficiencies at institutions to minimize losses to the DIF (Deposit Insurance Fund). The PCA framework provides benefits such as facilitating orderly closures and encouraging banks to increase capital levels. However, its reliance on capital means that problems with assets, earnings, or management may go unnoticed until it is too late.
To address this, regulators could consider non-capital triggers for PCA, such as measures of asset quality and liquidity, which have been shown to be important predictors of future bank failure. This would allow them to take early action to address deteriorating conditions at banks.
Another option is to raise the equity requirements for banks. Currently, a bank is considered "well capitalized" if it has equity equal to at least 5% of its assets. However, this threshold is too low—as demonstrated by SVB, which had a leverage ratio of 7.96% at the end of 2022 and still failed. By raising the threshold, banks would be required to shoulder a greater fraction of any losses in asset value or any runs on uninsured deposits. This would increase “self-insurance” against loss, change bank incentives, and reduce the likelihood of depositor runs by strengthening the balance sheet.
Regulators could also address the accounting practices that can mask a bank's true financial health. For example, the classification of assets as "held to maturity" can lead to inflated equity calculations and allow banks to appear solvent and above the regulatory threshold when they are not.
Finally, regulators should be more proactive in addressing concerns with banks. In the case of Silicon Valley Bank and Signature Bank, which failed in March 2023, regulators had identified concerns but were slow to act, and the banks were slow to mitigate the problems. More timely and effective supervisory actions could have prevented these failures.
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Frequently asked questions
There are two main accounting methods of recording loan losses: loan write-offs and the creation of provisions for loan losses (or bad and doubtful debts provisions).
Write-offs, sometimes called "charge-offs", are the final step of removing troubled assets from the balance sheet. Banks use write-offs to remove loans from their balance sheets and reduce their overall tax liability.
Banks are usually required to keep reserves for bad loans. When a bad debt is written down, part of the debt is recovered and part is written off, usually as part of a settlement.
