1 Thing Bank Investors Aren't Paying Enough Attention To

Investors generally see a rosy future for the banking industry, as rising interest rates should result in a larger spread between what banks earn on their loans and pay for their deposits. That much any bank investor can tell you.

But one thing I don't think investors are paying enough attention to is just how little banks have set aside for bad loans. Across the industry, banks have reserved just $1.24 for losses out of every $100 of loans on their balance sheets. You have to go all the way back to 2007 to find a time when banks had set aside less capital as a percentage of loans on their balance sheets.

Banks have set aside less for bad loans. Image source: Getty Images.

Smaller rainy day funds

Declining loss reserves have been a quiet driver of bank earnings for years now. Reserves are two-thirds lower than at their peak in 2010, when banks were paying for their underwriting sins prior to the financial crisis. 

Of course, not all banks are operating on thinner cushions. Credit card issuers have been building up their reserves recently. Synchrony Financial's (NYSE: SYF) allowance for loan losses increased from roughly 5.7% of loans to 6.8% of loans at the end of 2017. Likewise, American Express (NYSE: AXP), which is increasingly issuing cards to people who carry balances, now has reserves equal to 2.3% of its loans, up from 1.9% at the end of 2016.

Data source: Federal Reserve. Chart by author.

Credit card issuers can be canaries in a coal mine, since one would naturally expect losses in credit cards to tick up before losses rise in safer types of loans, like mortgages or car loans. It's notable to me that the megabanks -- which are more traditional lenders than card issuers -- haven't increased their reserves in any meaningful way in the past year.

Data source: Wells Fargo, JPMorgan, Bank of America, Citigroup presentations and earnings releases. Allowances are shown as a percentage of total loans.

Higher-quality loan portfolios?

The consensus among bank investors is that bank balance sheets are less risky today than in the past. In a recent interview with Bloomberg, Steve Eisman, who is featured in the book The Big Short, said that banks in the United States had largely cleaned up their loan portfolios, implying that banks have a better grip on their risks today than perhaps 10 years ago. (In the movie The Big Short, Eisman is played by Steve Carell.)

Eisman told Bloomberg that the banks "were forced to clean their balance sheets rapidly and bring leverage down rapidly." He also said that he hasn't "been this positive on banks since the 1990s."

To be sure, there is plenty of reason to be bullish on the banks. Interest rates are low, but they're rising, and problem loans are few and far between. Banks recently charged off only 0.52% of their loans on an annualized basis, roughly half the average since 1985. But for how long can this credit cycle -- now nine years old -- continue favoring the banking industry?

Guessing game

It's important to remember that when Bank of America says it earned $5.6 billion in the third quarter of 2017, that figure is the result of guesswork. It could have easily reported earnings of $4 billion or $6 billion, depending entirely on its estimates of just how much it would lose to lending errors.

Banking is one of the few businesses where companies don't know the true cost of their revenue until years later. Walmart knows how much it earns, with certainty, when it sells a package of socks to a customer. Banks don't have that luxury.

In banking, it's important not to fall for the immediately quantifiable and ignore things that aren't so easily quantified. Yes, banks will earn more as interest rates rise, assuming that loan losses remain near historical lows. Bank stock valuations seem to reflect that low loan losses are here to stay. I'm not so confident.