Friday, March 20, 2009

Why Would a Bank Try to Drive Its Borrowers Away?

Yes, some banks are trying to drive away their borrowers (the usual terms for this are “running off the portfolio”, or ”shrinking the balance sheet”). Why would they do this? It’s not intuitively obvious, but in theory at least it puts the bank in a better position to cope with future losses.

Unfortunately, to understand this it’s necessary to work through the numbers. Here is a simplified bank income statement and balance sheet:


I hope this is all obvious (I’m happy to address any questions in the comments). The scenario assumes all the loans are performing, but banks keep a loss reserve on their balance sheet just in case of future trouble. The bottom number is the key to understanding this topic; if things get really bad the bank is wiped out if it suffers a 12.2% loss on its loan portfolio.

Next, let’s assume a quarter passes with and there are no new loans or payoffs. The bank makes another $50,000,000 which increases its equity and ability to handle losses:


Now, let’s say instead of no new loans the bank drives away $500,000,000 of loans (how to do this is a separate topic). The bank no longer needs the deposits to fund those loans, so it drives them away too. Income goes down, but the ability of the bank to handle losses on the remaining portfolio goes up:


Is this a good strategy? There’s some problems with it (again, a separate post topic), but if your regulator tells you to increase your capital ratio its one of the few approaches you can take in this environment.