How to save struggling banks: Get tough with high-risk borrowers

Carla Fried | Sep 07, 2017

Sections Finance

In a perfect world, all banks would be able to withstand the punch of a severe economic downturn that causes loan performance to degrade and profits to shrivel. But as recently as the 2007–10 financial crisis, robust central-bank intervention was needed to shore up distressed banking systems.

Subsequent policy shifts, such as increases in capital requirements, and ongoing stress testing may help reduce the number of banks that fail because of economic shocks. But these policies are unlikely to eliminate the problem of banks in distress. This raises a question: When a bank suffers a deep downturn, is there any way to gauge its likelihood of recovering?

Emilia Bonaccorsi di Patti of the Bank of Italy and Chicago Booth’s Anil K Kashyap find a potential “idiosyncratic” factor correlated to the bouncing back of distressed banks. Setting aside the issue of liquidity—or depositor runs, which often precipitate seizure by banking regulators—the researchers focus their analysis on loan quality.

“Recovery depends primarily on post-shock adjustments made by the banks, particularly to their loan portfolios,” the researchers write.

Di Patti and Kashyap followed the fortunes of 110 Italian banks that took a severe blow to profitability in the mid-1990s, a period when the country experienced a deep recession during which more than 9 percent of bank loans were nonperforming and the loan default rate more than doubled to a high of 4 percent. They then monitored how the banks fared as the economy recovered.

The 30 banks that saw a significant rebound in their return on assets (ROA) in the following three years were “significantly more aggressive in managing their riskiest clients” than the banks that didn’t recover—“managing” here meaning they raised their lending standards to reduce default exposure.

Some banks cut off credit to troubled borrowers, whereas others extended additional loans, hoping to see a client through a crisis to a turnaround. The research suggests the former approach is more successful.

Zeroing in on the banks’ riskiest corporate borrowers with the highest probability of defaulting, the research pushes back against the notion that continuing to provide more credit will pay off for the lender. The banks that did not get a substantial profit recovery reduced their lending to their clients deemed at the highest risk of defaulting by just 4 percentage points a year. The banks that managed to work their way back were more abstemious with their high-risk corporate borrowers, cutting those loan portfolios by 13 percentage points a year in the three years following the banks’ profit shock.

In another pass at the data, the researchers omitted the three largest banks in the study to see if the banks’ large footprint was skewing results, but this only amplified the finding. In this subset, nonrecovering banks didn’t adjust their credit lending to high-risk customers, while the recovering banks cut credit to those firms by an average of 16 percentage points per year.

The research findings could help regulators measure the potential outcomes of intervention. “Regulators tend to disclose relatively little about what steps are taken with respect to banks that require intervention. Our findings suggest paying close attention to whether the distressed banks are being particularly vigilant in containing credit to high risk borrowers.”