How We Know Another Credit Crisis Is Coming

Further to yesterday's article on bank earnings declining, one of the better discussions on the topic comes from the St. Louis Fed of all places.

They stress that a decline in earnings is one of the earliest indicators that a particular bank will fail.

Considering the high Credit Default Swap numbers we see on many institutions presently and these premiums are rising!

Spend some time reflecting upon sections of the following article:

Earliest Indicator of Bank Failure Is Deterioration in Earnings

The Great Recession (roughly the period from late-2007 to mid-2009) will go down as an extraordinary period for the U.S. banking sector.1 In addition to the distress faced by the largest investment and commercial banks, 168 depository institutions failed from 2007 through 2009. Although this may seem like a relatively small number when compared with the 1,858 banks and thrifts that failed from 1987 to 1993 during the height of the savings and loan crisis, the dollar value of failed bank assets is unmatched. Thus far, the Great Recession has seen roughly $540 billion of failed bank assets, which is roughly 1.5 times the dollar value of assets that failed in 1987-1993.2

When investors, journalists and other interested parties look for signs of weakness in the banking sector, they tend to analyze data reported by banks in their quarterly Reports on Condition and Income (or call reports). Regulatory agencies, however, can identify signs of bank weakness through a unique prism—the CAMELS ratings that the agencies assign banks following examinations. Captured in these ratings is information gleaned from an examiner’s intimate knowledge of an institution that can be used to construct expectations for the future prospects of the banking organization.

Analysis of the S&L crisis suggests that the banks and thrifts that failed were particularly exposed to poor asset quality, poor risk management and passive bank management. In the contemporary episode of bank failures, asset quality issues in the commercial real estate sector are a particular problem, but in general, the reasons for failures in the past are the reasons for failure today.3

The results of our analysis were not surprising. Banks that fail experience deterioration in asset quality. The deterioration first shows in a bank’s earnings level (the “E” component of CAMELS) as banks begin to provision for potential loan losses. This occurs well in advance of other financial health indicators.

The next CAMELS components to show deterioration are “asset quality” and “management,” both hitting the 3 mark nine quarters before failure. Not surprisingly, the management component rating starts to deteriorate soon after the earnings component does, reflecting ongoing asset quality issues and regulatory initiatives by bank supervisors to clearly communicate with management, as well as hold management accountable for the bank’s conditions.4

 In conclusion, while weakened or deteriorating asset quality is the primary driver of bank stress, the recognition of this stress has historically first shown up in earnings performance. This stress is next reflected in a bank’s management rating as, in the case of an institution that ultimately fails, bank management is unable to reverse the negative trends in earnings and asset quality. Capital ratios, while important, tend to deteriorate well after the bank’s condition has weakened.