Despite financial stocks rebounding in recent weeks, a number of regional banks face high risk of steep sell-offs due to declines in their reserves for loan losses. Recently released loan-loss reserve numbers from Citizens Financial Group Inc. (CFG), Fifth Third Bancorp (FITB), Zions Bancorp (ZION) and Regions Financial Corp. (RF), revealed that their total allowances for loans had dipped to considerably low levels, making them vulnerable in the case of a deterioration in the credit quality of their loan books, according to Barron’s.

Regional Banks: Less Cushion for Losses

 Year  Total Allowance for Loans*
 2018  1.11%
 2009  3.00%

Source: Barron’s; *as a percentage of loans and leases

Total allowances for loans as a percentage of loans and leases among the large regional banks fell 0.07% from last year’s 1.18% and are now lower than they were nearly ten years ago, when the U.S. financial system was just beginning to regain its footing after a near collapse. Citizens Financial Group’s total allowances fell from 1.11% a year ago to 1.08%, Fifth Third’s from 1.31% to 1.17%, Zions’ from 1.23% to 1.05%, and Regions Financial’s from 1.31% to 1.03%.

What It Means

Each quarter, banks set aside provisions for loan losses. While adding to the total loan-loss reserve amount on the balance sheet. Those provisions must pass through the income statement, directly reducing earnings. By lowering those provision amounts, banks can inflate earnings, but it means having less of a buffer in the case that loans get charged-off.

At the moment, credit losses are so low that banks have become more relaxed, especially compared to their extremely cautious stance following the financial crisis. The current strength of the economy has given banks the confidence to reduce loan-loss provisions, putting aside just enough to match charge-offs, and consequently providing an added boost to earnings.

"Credit costs are low until they are high. They don't go up in a linear fashion."—Marty Mosby, Vining Sparks

But while the credit quality of loan portfolios for large regional banks may look healthy right now, that situation can change quickly. Although Marty Mosby, director of bank and equity strategies at Vining Sparks, doesn’t see an imminent shift that would affect the current credit environment, he does caution about the inherently difficult nature of trying to predict when a healthy credit environment becomes toxic. 

What’s Next

Moving forward, investors will want to keep an eye on the credit quality of banks’ loan books and whether or not loan-loss reserves continue to decline. Considering their current level, further declines at this point are a definite red flag.

Of course, there are some who are confident that amid rising rates, which tend to allow banks to increase their net interest margins, the banking sector is well positioned for strong performance. Then again, at least in this current cycle of monetary tightening by the U.S. Federal Reserve, bank stock performance has been relatively lackluster.