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Federal Reserve Bank of Cleveland
holding company equity, the 1981 net
charge off ratio, the 1981 nonperforming
loan ratio,_ and the percentage change in
total loans in 1981. All four of these variables are positively correlated with 1982
charge offs, the first three significantly.
Net charge off ratios also can be influenced by holding company loan composition. Total loans are divided into four
categories in the annual reports of holding companies-commercial
and industrial, real estate construction, real estate
mortgage, and consumer. Thus, four loan
composition ratios can be constructed by
dividing each subtotal by total loans. Both
the commercial and industrial loans and
the real estate construction loan ratios
are positively correlated with holding
company net charge offs. The real estate
mortgage loan and consumer loan ratios
are negatively correlated with holding
company loan losses. This finding is
somewhat surprising, as consumer loans
have been viewed as increasingly risky
since the 1979 changes in federal bankruptcy laws.
The rate sensitivity of a holding company's loan portfolio also can affect its
loan quality. The unprecedented
volatility
of interest rates in recent years has
exposed banking organizations to considerably more interest-rate risk than in
the past. Many organizations have
responded by transferring as much of the
increase in interest-rate risk as possible to
borrowers through the use of short-term
fixed-rate and floating-rate loans. However, because some borrowers might be
unable to deal with interest-rate risk, this
tactic may serve to increase a company's
credit risk while decreasing its exposure
to interest-rate changes. The positive,
significant correlation between the loan
quality ratio and the rate-sensitive loan
ratio suggests that credit risk was substituted for interest-rate risk. However, this
relationship might weaken in the future if
interest rates trend lower and exhibit
more stable behavior.
The extent of holding company diversification, both product line and geo-

Table 3 Loan Quality Ratios vs.
Measures of Performance
Loan quality ratios
Performance
measures

Net charge
Nonperforming
offs/average
loans/average
net loans, 1982 net loans, 1981

Percent change,
net interest
margin,1981-82
Return on average
assets, 1982
Rate of growth,
earningsper share,
1978-82
Marketprice per
share of equity/
earningsper share"

-0.05

-0.13

-OA1*

-0.17

-0.27*

-0.28*

-0.13

-0.18

* Significant t 5 percent level,two-tailtest.
a
a. Averageof year-end 1982and 1983:IQ
data.
graphic, could be related to a holding
company's loan quality. Such diversification should reduce charge offs. Holding
company size is used as a crude proxy for
both types of diversification. The size variable exhibits the anticipated indirect relationship to the net charge off ratio. However, the correlation is statistically weak.
The quality of holding company loans
should be related to the condition of the
local economy (which, of course, depends
on the national economy). The unemployment rate in the headquarters'
state
of each sample company was used as an
indicator of local economic conditions. As
expected, this variable was positively correlated with the net charge off ratio. The
implication of this finding is that the level
of holding company loan losses and nonperforming loans in the future will depend
critically on the timing and strength of the
incipient economic recovery.
Loan Quality and Bank Performance
The impact of loan quality levels on
holding company performance is of interest for several reasons. Sustained high
levels of loan losses and non performing
loans can negatively affect a company's
earnings, making it more difficult and/or
more expensive for organizations to
augment their capital positions over time

or borrow funds in national money
markets. Strong capital positions and the
ability to raise funds without paying
excessive risk premiums might be essential for survival in the future as deregulation proceeds and competition intensifies.
To obtain insight on this issue, the 1982
net charge off ratio and the 1981 nonperforming loan ratio were correlated with
several indicators of holding company
performance-percent
change in net
interest margin, return on assets, growth
in income per share, and market value
per share of equity relative to earnings
per share (see table 3). The latter performance measure is particularly useful
for analysis, because it reflects the value
that investors place on an institution's
accounting earnings.
The correlations confirm the intuitive
notion that deterioration in loan quality
adversely affects holding company performance. Specifically, higher loan loss
and nonperforming loan ratios are associated with smaller percentage increases
in net interest margins, lower return on
assets, slower growth in earnings per
share, and lower price-earnings ratios.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland,OH
44101

Conclusion
Net charge offs at bank holding companies increased sharply in 1982, after
declining in 1981. Despite the length and
severity of the recession, loan-loss levels
generally remain below the peaks reached
in the 1974-75 recession. Nonperforming loan levels have risen since 1979 and
are likely to trend higher in the 1982-83
period. Whether this rise in nonperforming loans will produce higher loan losses
depends on the course of economic activity. The data suggest that holding companies have the capability to endure
higher loan losses should they materialize.
The data also suggest that loan quality
affects holding company performance.
Thus, loan quality will have important
effects on the ability of holding companies
to raise funds in national money and capital markets, particularly now that banking
organizations will be required to disclose
more detailed information about their
problem loans. Funds availability and cost
may be the critical factors influencing a
holding company's prospects for survival
and growth in today's increasingly competitive financial environment.
BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Economic Commentary

ISSN0428-1276

Loan Quality of Bank Holding Companies
by Gary Whalen
Like most types of depository institutions, commercial banks operate with a
high degree of financial leverage; that is,
their equity typically is small relative to
their total assets. As a result, the loan
quality and solvency of commercial banks
are inextricably related. For this reason
banking regulators, who are charged with
preserving the safety and soundness of
the nation's banking system, are concerned with bank loan quality; businesses
and households, who supply banks with
investable funds, share these concerns.
Loan quality is largely a function of the
financial health of a bank's borrowers.
Because of the recession, disinflation,
persistently high interest rates, and heavy
corporate and consumer reliance on
debt, it has become increasingly difficult
for many classes of borrowers to repay
their bank loans. The resulting deterioration in loan quality at many banks is the
subject of this Economic Commentary,
which explores recent changes in loan
quality at a cross-section of 60 regional
bank holding companies located in 12
states. 1 The article identifies the factors
responsible for variations in loan quality
across holding companies and discusses
the impact of changes in loan quality.
Indicators
of Loan Quality
Two indicators of a holding company's
loan quality are used in this study-net

Address Correction
Requested:
Reserve Bank of Cleveland.Research

Please send corrected mailing label to the Federal
Department, P.O. Box 6387, Cleveland, OH 44101.

March 21, 1983

1. Companieswere drawn nonrandomlyfromthe
twelvestates in the study, as follows: labama,five;
A
Colorado,four; Florida,seven; Massachusetts,
three; Michigan,two; Missouri,four; NewJersey,
six; Ohio, four;Tennessee, three; Texas, six; Virginia,seven;and Wisconsin,nine. The analysisof
consolidatedholdingcompanydata presumes that
the fortuneof a typicalcompanyis primarilya function of the performanceof its bank affiliates.

loan charge offs and non performing
loans. Net charge offs are the total
amount of loans judged to be uncollectible in a given year, minus any recoveries
of loans previously charged off.2 Nonperforming loans, which include nonaccrual loans, renegotiated loans, and
loans with principal and/or interest payments contractually past due 90 days or
more, are a second indicator of loan
quality. Nonperforming loans imply that
there has been some deterioration in the
financial condition of the borrower.
Thus, total nonperforming loans give
some indication of future net loan charge
off levels. However, not all nonperforming loans are subsequently charged off.
More importantly, nonperforming loan
totals also provide insight on the shortrun earnings impact of problem loans.
Slower payback of principal and/or
interest payments on non performing
loans imply lower bank earnings.
Since net charge off and nonperforming loan levels increase with an institution's loan volume, it is necessary to
transform each indicator into an associated loan quality ratio-dividing
each
measure by a holding company's average
total loans-before
analyzing loan quality
across banks and/or over time. The
means, standard deviations, and ranges
of these ratios for the 60 sample companies since 1979 are shown in table 1. The
2. Recoveriesaverage 15to 22 percent of annual
gross loan charge offsat bank holdingcompanies.
The author is an economist with the Federal
Reserve Bank of Cleveland. Research assistance
was provided by June Gates.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

Table I Indicators of Holding Company Loan Quality
Values in percent; numbers in parentheses represent median value of ratio
Ratio"

1

2

3

4

Sb

6

7

0.38
(0.31)

c

36.7
(26.7)

74.4
(71.9)

8.56
(6.91)

3.3
(2.7)

c

Standard deviation 0.25

c

30.4

24.1

6.45

2.5

c

Range

c

4.4-146.4

31.0-144.1

1.79-36.98

0.4-1.5

c

1979
Mean

0.05-1.3

1980
Mean

0.46
(0.39)

Standard deviation 0.42
Range

0.06-3.1

1.73
(1.50)

40.6
(34.5)

80.7
(82.1)

7.37
(5.62)

1.01

37.7

20.4

0.3-5.8

4.4-281.1

17.9-145.2

4.0
(3.0)

15.0
(13.0)

6.20

4.3

10.3

0.31-37.44

0.4-33.0

1.0-61.4

1981
Mean

0.39
(0.33)

2.10
(1.91)

32.2
(29.4)

80.7
(78.7)

7.35
(5.99)

3.1
(2.8)

Standard deviation 0.22

1.20

17.8

22.4

4.68

1.7

10.2

Range

0.5-5.4

5.7-98.8

32.0-129.5

1.64-24.76

0.5-10.6

2.5-43.7

0.07-1.1

17.3
(15.3)

1982
Mean

na

44.5
(34.8)

78.0
(77.0)

5.21
(5.09)

4.7
(3.7)

na
na

Standard deviation 0.42

na

20.4

17.0

1.91

3.5

na

Range

na

20.7-108.2

38.9-113.4

1.42-9.58

2.1-23.9

na

0.58
(0.45)

0.3-2.7

a. Explanation of ratio numbers:
1. Net charge ofts/average net loans
5. Net operating income plus provision for loan
2. Nonperforming loans/average net loans
losses/net charge offs
3. Net charge ofts/reserves for loan losses
6. Net charge offs/equity
4. Net charge offs/provision for loan losses
7. Nonperforming loans/equity
b. These figures represent the number of times net operating income plus provision for loan losses could
absorb net charge offs.
c. Because the reporting requirement for nonperforming loans was changed after 1979, the 1979 and 1980
non performing loan figures are not comparable.

median values of these ratios are shown
in parentheses; unlike the means, they
are not distorted by extreme values of
the ratios being examined.
The mean value of the net charge off
ratio (ratio 1, table 1) has been above the
1979 mean in every year in the 1980-82
interval, The mean ratios have not steadily increased over the period. After an
increase in 1980, the mean charge off
ratio declined slightly in 1981. However,
this decline was reversed in 1982. The
1982 average charge off ratio is sharply
above the level of each of the three previous years. Still, the 1982 average
remains below the peak level recorded

during the 1974-75 downturn.3
The median levels of the net charge
off ratio exhibit similar behavior,
although they are below the mean level
in each year. As already noted, this indicates that several holding companies
typically experience high (relative to
their peers) loan losses in anyone year.
The rather large size of the standard
deviation and the range of the net
charge off ratio in every year also sug3. Net charge off ratios peaked in the 0.60 percent
to 0.65 percent range in the 1974-75 recession; see
Robert E. Norton, "Loan Losses Not Expected to
Harm Bank Earnings," American Banker, vol. 147,
no. 129 (July 6, 1982).

gests that annual loan loss levels vary
considerably across companies.
Examination of the mean level of the
nonperforming loan ratio (ratio 2, table 1)
over time reveals that problem loans generally have increased over the 1980-81
interval, While 1982 nonperforming loan
data are not yet available for the companies in this sample, analysts expect this
upward trend to continue, with this ratio
being in the 3 percent to 5 percent range
by the fourth quarter of the year.4 Since
nonperforming loan levels tend to be
related to realized loan losses with some
lag, this finding suggests that net loan
charge offs might increase rather than
decrease in the future. Once again, the
standard deviations and ranges show
considerable variation in nonperforming
loan levels across banks.
While the ratios discussed here give
some indication of holding company loan
quality, it is possible, and perhaps more
appropriate, to look at other ratios in
which net charge offs and nonperforming
loans are related to various measures
that reflect the ability of banks to cover
actual and prospective loan losses.
The first line of defense for a bank or a
bank holding company against anticipated loan losses is the valuation reserve
for loan losses. These reserves exist
because banks have been permitted to
deduct amounts from taxable income for
prospective loan losses (the provision for
loan losses) in excess of their realized net
loan charge offs in any particular
year.5 At the end of the year, a banking
organization's net loan losses are
"charged" against its loan-loss reserves
rather than against its current earnings.
An organization's earnings thus remain
insulated from its loan losses, as long as
its net loan charge offs in any year are
4. See Norton, "Loan Losses Not Expected to
Harm Bank Earnings."
5. The annual change in a bank's loan-loss reserves
is the difference between its provision for loan
losses and its net charge offs. When the former
exceeds the latter, reserves increase and vice versa.

less than its total loan-loss reserves.6
This discussion suggests that net
charge offs should be compared not only
with a holding company's total volume of
loans but also with its reserves for loan
losses (ratio 3, table 1). Over the past
four years, loan-loss reserves in general
have been sufficient to absorb realized
loan losses. Like the net charge off ratio,
the mean value of net charge offs relative
to loan-loss reserves has not increased
steadily over time, but it was higher in
1982 than in the three previous years.
Again, a great deal of variation in this
ratio is apparent across holding companies in every year. This ratio is very
high for several institutions in anyone
year. This explains the larger size of the
mean relative to the median. However, in
1982 the minimum and maximum values
of this ratio are both above their respective levels in 1981, and the range is
narrower. This finding, along with the
decrease in the size of the standard deviation relative to the mean, suggests that
loan quality became a bigger problem for
many of the sample companies in 1982.
Examining net charge offs in relation to
a holding company provision for loan
losses (ratio 4, table 1) indicates whether
holding companies have been able to
effect a net increase in their loan-loss
reserves in any given year, despite their
charge offs. A company's loan-loss
reserves increase as long as this ratio is
less than 100 percent.
6. Because banks were permitted to charge a provision for loan loss against income in excess of actual
loan losses, there was an incentive to inflate this expense (and loan-loss reserves) to decrease their tax liability. To prevent this, gradually declining maximum
loan-loss reserves ratios (loan-loss reserves divided
by average loans) were established for banks by the
Tax Reform Act of 1969. However, the scheduled reo
duction for 1982 was postponed for one year by the
Economic Recovery Tax Act of 1981. The 1969 act
also stipulated that, beginning in 1988, permissible
bank loan-loss reserves ratios would depend on their
average actual loan-loss experience over the recent
past. For a discussion of bank loan-loss practices and
pertinent regulations, see Stuart A Schweitzer, "Bank
Loan Losses: A Fresh Perspective," Business Review,
Federal Reserve Bank ofPhiladelphia, September 1975.

Even though loan losses generally
increased after 1979, net charge offs have
remained below holding company provisions for loan losses. The mean value of
this ratio for the sample companies was
80.7 percent in 1980 and 1981, and it even
declined slightly in 1982. The median
value behaved similarly. Thus, most sample holding companies evidently were
able to boost their loan-loss reserves over
the 1979-82 interval, Again, considerable
variation in this ratio is apparent, but the
variation does not appear to be increasing much over time.
Loan-loss reserves are intended to absorb anticipated loan losses. If losses are
unexpectedly severe, a company then can
use its current earnings to absorb loan
losses. So-called loan coverage ratios indicate a company's ability to utilize its
earnings for this purpose. The mean and
median values of such a ratio (ratio 5,
table 1) have declined steadily since 1979.
However, earnings available to cover loan
losses at a typical holding company remain
five times greater than 1982 charge offs.
Equity capital is the final defense
against unusually large loan losses. In
ratios 6 and 7, net charge offs and nonperforming loans, respectively, are
divided by holding company equity. The
mean value of ratio 6 declined in 1981
compared with the two previous years,
but increased in 1982. Variability also
appears to have increased in 1982 relative to previous years. The mean value of
ratio 7 has increased over the 1980-81
interval, and it should be even higher in
1982 if estimates of nonperforming loan
levels prove correct. Since variability
remained relatively unchanged in 1981,
the increase in this mean from 1980 to
1981 seems to indicate that nonperforming loans rose at virtually all of the sample companies rather than simply being
much higher at only a few companies.
The larger means of these last two ratios
relative to their counterparts
(ratios 1
and 2, which have a loan-volume measure in the denominator) graphically illustrate the high degree of financial leverage

Table 2 Loan Quality Ratios vs.
Potential Determinants

Determinants

Net charge
offs/average
net loans, 1982

Standard deviation, quarterly
rate of return on share of
equity, 1980:IQ-1981:IVQ

0.29*

Net charge offs/average net
loans, 1981

0.52*

Nonperforming loans/average
net loans, 1981

0.46*

Percent change in net loans,

0.12

1981-80

Commercial and industrial loans/
average net loans, 1981

0.22

Real estate construction loans/
average net loans, 1981

0.31*

Real estate mortgage loans/
average net loans, 1981

-0.28*

Consumer loans/average net
loans, 1981

-0.13

Rate-sensitive loans'yaverage
net loans
Holding company total
assets, 1982
State unemployment rate
(average), 1982

0.30·
-0.14
0.21

* Significant at 5 percent level, two-tail test.
a. Rate-sensitive loans are loans with maturities
of less than one year plus floating-rate loans.
utilized by depository institutions, indicating why loan quality is of great concern to regulators, consumers, and the
business sector alike.

Measured Loan Quality
Each holding company's loan quality is
a product of several factors-its
preference for risk, its loan portfolio composition, and the state of the local economy,
among others. Correlating possible
explanatory variables with each holding
company's 1982 net charge off ratio helps
to identify the most important forces
influencing loan quality.
Companies that attempt to earn higher
returns by taking on more risk may experience higher loan losses. Several variables are used in table 2 as risk-posture
proxies-the
standard deviation of the
quarterly rate of return on a share of

Table I Indicators of Holding Company Loan Quality
Values in percent; numbers in parentheses represent median value of ratio
Ratio"

1

2

3

4

Sb

6

7

0.38
(0.31)

c

36.7
(26.7)

74.4
(71.9)

8.56
(6.91)

3.3
(2.7)

c

Standard deviation 0.25

c

30.4

24.1

6.45

2.5

c

Range

c

4.4-146.4

31.0-144.1

1.79-36.98

0.4-1.5

c

1979
Mean

0.05-1.3

1980
Mean

0.46
(0.39)

Standard deviation 0.42
Range

0.06-3.1

1.73
(1.50)

40.6
(34.5)

80.7
(82.1)

7.37
(5.62)

1.01

37.7

20.4

0.3-5.8

4.4-281.1

17.9-145.2

4.0
(3.0)

15.0
(13.0)

6.20

4.3

10.3

0.31-37.44

0.4-33.0

1.0-61.4

1981
Mean

0.39
(0.33)

2.10
(1.91)

32.2
(29.4)

80.7
(78.7)

7.35
(5.99)

3.1
(2.8)

Standard deviation 0.22

1.20

17.8

22.4

4.68

1.7

10.2

Range

0.5-5.4

5.7-98.8

32.0-129.5

1.64-24.76

0.5-10.6

2.5-43.7

0.07-1.1

17.3
(15.3)

1982
Mean

na

44.5
(34.8)

78.0
(77.0)

5.21
(5.09)

4.7
(3.7)

na
na

Standard deviation 0.42

na

20.4

17.0

1.91

3.5

na

Range

na

20.7-108.2

38.9-113.4

1.42-9.58

2.1-23.9

na

0.58
(0.45)

0.3-2.7

a. Explanation of ratio numbers:
1. Net charge ofts/average net loans
5. Net operating income plus provision for loan
2. Nonperforming loans/average net loans
losses/net charge offs
3. Net charge ofts/reserves for loan losses
6. Net charge offs/equity
4. Net charge offs/provision for loan losses
7. Nonperforming loans/equity
b. These figures represent the number of times net operating income plus provision for loan losses could
absorb net charge offs.
c. Because the reporting requirement for nonperforming loans was changed after 1979, the 1979 and 1980
non performing loan figures are not comparable.

median values of these ratios are shown
in parentheses; unlike the means, they
are not distorted by extreme values of
the ratios being examined.
The mean value of the net charge off
ratio (ratio 1, table 1) has been above the
1979 mean in every year in the 1980-82
interval, The mean ratios have not steadily increased over the period. After an
increase in 1980, the mean charge off
ratio declined slightly in 1981. However,
this decline was reversed in 1982. The
1982 average charge off ratio is sharply
above the level of each of the three previous years. Still, the 1982 average
remains below the peak level recorded

during the 1974-75 downturn.3
The median levels of the net charge
off ratio exhibit similar behavior,
although they are below the mean level
in each year. As already noted, this indicates that several holding companies
typically experience high (relative to
their peers) loan losses in anyone year.
The rather large size of the standard
deviation and the range of the net
charge off ratio in every year also sug3. Net charge off ratios peaked in the 0.60 percent
to 0.65 percent range in the 1974-75 recession; see
Robert E. Norton, "Loan Losses Not Expected to
Harm Bank Earnings," American Banker, vol. 147,
no. 129 (July 6, 1982).

gests that annual loan loss levels vary
considerably across companies.
Examination of the mean level of the
nonperforming loan ratio (ratio 2, table 1)
over time reveals that problem loans generally have increased over the 1980-81
interval, While 1982 nonperforming loan
data are not yet available for the companies in this sample, analysts expect this
upward trend to continue, with this ratio
being in the 3 percent to 5 percent range
by the fourth quarter of the year.4 Since
nonperforming loan levels tend to be
related to realized loan losses with some
lag, this finding suggests that net loan
charge offs might increase rather than
decrease in the future. Once again, the
standard deviations and ranges show
considerable variation in nonperforming
loan levels across banks.
While the ratios discussed here give
some indication of holding company loan
quality, it is possible, and perhaps more
appropriate, to look at other ratios in
which net charge offs and nonperforming
loans are related to various measures
that reflect the ability of banks to cover
actual and prospective loan losses.
The first line of defense for a bank or a
bank holding company against anticipated loan losses is the valuation reserve
for loan losses. These reserves exist
because banks have been permitted to
deduct amounts from taxable income for
prospective loan losses (the provision for
loan losses) in excess of their realized net
loan charge offs in any particular
year.5 At the end of the year, a banking
organization's net loan losses are
"charged" against its loan-loss reserves
rather than against its current earnings.
An organization's earnings thus remain
insulated from its loan losses, as long as
its net loan charge offs in any year are
4. See Norton, "Loan Losses Not Expected to
Harm Bank Earnings."
5. The annual change in a bank's loan-loss reserves
is the difference between its provision for loan
losses and its net charge offs. When the former
exceeds the latter, reserves increase and vice versa.

less than its total loan-loss reserves.6
This discussion suggests that net
charge offs should be compared not only
with a holding company's total volume of
loans but also with its reserves for loan
losses (ratio 3, table 1). Over the past
four years, loan-loss reserves in general
have been sufficient to absorb realized
loan losses. Like the net charge off ratio,
the mean value of net charge offs relative
to loan-loss reserves has not increased
steadily over time, but it was higher in
1982 than in the three previous years.
Again, a great deal of variation in this
ratio is apparent across holding companies in every year. This ratio is very
high for several institutions in anyone
year. This explains the larger size of the
mean relative to the median. However, in
1982 the minimum and maximum values
of this ratio are both above their respective levels in 1981, and the range is
narrower. This finding, along with the
decrease in the size of the standard deviation relative to the mean, suggests that
loan quality became a bigger problem for
many of the sample companies in 1982.
Examining net charge offs in relation to
a holding company provision for loan
losses (ratio 4, table 1) indicates whether
holding companies have been able to
effect a net increase in their loan-loss
reserves in any given year, despite their
charge offs. A company's loan-loss
reserves increase as long as this ratio is
less than 100 percent.
6. Because banks were permitted to charge a provision for loan loss against income in excess of actual
loan losses, there was an incentive to inflate this expense (and loan-loss reserves) to decrease their tax liability. To prevent this, gradually declining maximum
loan-loss reserves ratios (loan-loss reserves divided
by average loans) were established for banks by the
Tax Reform Act of 1969. However, the scheduled reo
duction for 1982 was postponed for one year by the
Economic Recovery Tax Act of 1981. The 1969 act
also stipulated that, beginning in 1988, permissible
bank loan-loss reserves ratios would depend on their
average actual loan-loss experience over the recent
past. For a discussion of bank loan-loss practices and
pertinent regulations, see Stuart A Schweitzer, "Bank
Loan Losses: A Fresh Perspective," Business Review,
Federal Reserve Bank ofPhiladelphia, September 1975.

Even though loan losses generally
increased after 1979, net charge offs have
remained below holding company provisions for loan losses. The mean value of
this ratio for the sample companies was
80.7 percent in 1980 and 1981, and it even
declined slightly in 1982. The median
value behaved similarly. Thus, most sample holding companies evidently were
able to boost their loan-loss reserves over
the 1979-82 interval, Again, considerable
variation in this ratio is apparent, but the
variation does not appear to be increasing much over time.
Loan-loss reserves are intended to absorb anticipated loan losses. If losses are
unexpectedly severe, a company then can
use its current earnings to absorb loan
losses. So-called loan coverage ratios indicate a company's ability to utilize its
earnings for this purpose. The mean and
median values of such a ratio (ratio 5,
table 1) have declined steadily since 1979.
However, earnings available to cover loan
losses at a typical holding company remain
five times greater than 1982 charge offs.
Equity capital is the final defense
against unusually large loan losses. In
ratios 6 and 7, net charge offs and nonperforming loans, respectively, are
divided by holding company equity. The
mean value of ratio 6 declined in 1981
compared with the two previous years,
but increased in 1982. Variability also
appears to have increased in 1982 relative to previous years. The mean value of
ratio 7 has increased over the 1980-81
interval, and it should be even higher in
1982 if estimates of nonperforming loan
levels prove correct. Since variability
remained relatively unchanged in 1981,
the increase in this mean from 1980 to
1981 seems to indicate that nonperforming loans rose at virtually all of the sample companies rather than simply being
much higher at only a few companies.
The larger means of these last two ratios
relative to their counterparts
(ratios 1
and 2, which have a loan-volume measure in the denominator) graphically illustrate the high degree of financial leverage

Table 2 Loan Quality Ratios vs.
Potential Determinants

Determinants

Net charge
offs/average
net loans, 1982

Standard deviation, quarterly
rate of return on share of
equity, 1980:IQ-1981:IVQ

0.29*

Net charge offs/average net
loans, 1981

0.52*

Nonperforming loans/average
net loans, 1981

0.46*

Percent change in net loans,

0.12

1981-80

Commercial and industrial loans/
average net loans, 1981

0.22

Real estate construction loans/
average net loans, 1981

0.31*

Real estate mortgage loans/
average net loans, 1981

-0.28*

Consumer loans/average net
loans, 1981

-0.13

Rate-sensitive loans'yaverage
net loans
Holding company total
assets, 1982
State unemployment rate
(average), 1982

0.30·
-0.14
0.21

* Significant at 5 percent level, two-tail test.
a. Rate-sensitive loans are loans with maturities
of less than one year plus floating-rate loans.
utilized by depository institutions, indicating why loan quality is of great concern to regulators, consumers, and the
business sector alike.

Measured Loan Quality
Each holding company's loan quality is
a product of several factors-its
preference for risk, its loan portfolio composition, and the state of the local economy,
among others. Correlating possible
explanatory variables with each holding
company's 1982 net charge off ratio helps
to identify the most important forces
influencing loan quality.
Companies that attempt to earn higher
returns by taking on more risk may experience higher loan losses. Several variables are used in table 2 as risk-posture
proxies-the
standard deviation of the
quarterly rate of return on a share of

Table I Indicators of Holding Company Loan Quality
Values in percent; numbers in parentheses represent median value of ratio
Ratio"

1

2

3

4

Sb

6

7

0.38
(0.31)

c

36.7
(26.7)

74.4
(71.9)

8.56
(6.91)

3.3
(2.7)

c

Standard deviation 0.25

c

30.4

24.1

6.45

2.5

c

Range

c

4.4-146.4

31.0-144.1

1.79-36.98

0.4-1.5

c

1979
Mean

0.05-1.3

1980
Mean

0.46
(0.39)

Standard deviation 0.42
Range

0.06-3.1

1.73
(1.50)

40.6
(34.5)

80.7
(82.1)

7.37
(5.62)

1.01

37.7

20.4

0.3-5.8

4.4-281.1

17.9-145.2

4.0
(3.0)

15.0
(13.0)

6.20

4.3

10.3

0.31-37.44

0.4-33.0

1.0-61.4

1981
Mean

0.39
(0.33)

2.10
(1.91)

32.2
(29.4)

80.7
(78.7)

7.35
(5.99)

3.1
(2.8)

Standard deviation 0.22

1.20

17.8

22.4

4.68

1.7

10.2

Range

0.5-5.4

5.7-98.8

32.0-129.5

1.64-24.76

0.5-10.6

2.5-43.7

0.07-1.1

17.3
(15.3)

1982
Mean

na

44.5
(34.8)

78.0
(77.0)

5.21
(5.09)

4.7
(3.7)

na
na

Standard deviation 0.42

na

20.4

17.0

1.91

3.5

na

Range

na

20.7-108.2

38.9-113.4

1.42-9.58

2.1-23.9

na

0.58
(0.45)

0.3-2.7

a. Explanation of ratio numbers:
1. Net charge ofts/average net loans
5. Net operating income plus provision for loan
2. Nonperforming loans/average net loans
losses/net charge offs
3. Net charge ofts/reserves for loan losses
6. Net charge offs/equity
4. Net charge offs/provision for loan losses
7. Nonperforming loans/equity
b. These figures represent the number of times net operating income plus provision for loan losses could
absorb net charge offs.
c. Because the reporting requirement for nonperforming loans was changed after 1979, the 1979 and 1980
non performing loan figures are not comparable.

median values of these ratios are shown
in parentheses; unlike the means, they
are not distorted by extreme values of
the ratios being examined.
The mean value of the net charge off
ratio (ratio 1, table 1) has been above the
1979 mean in every year in the 1980-82
interval, The mean ratios have not steadily increased over the period. After an
increase in 1980, the mean charge off
ratio declined slightly in 1981. However,
this decline was reversed in 1982. The
1982 average charge off ratio is sharply
above the level of each of the three previous years. Still, the 1982 average
remains below the peak level recorded

during the 1974-75 downturn.3
The median levels of the net charge
off ratio exhibit similar behavior,
although they are below the mean level
in each year. As already noted, this indicates that several holding companies
typically experience high (relative to
their peers) loan losses in anyone year.
The rather large size of the standard
deviation and the range of the net
charge off ratio in every year also sug3. Net charge off ratios peaked in the 0.60 percent
to 0.65 percent range in the 1974-75 recession; see
Robert E. Norton, "Loan Losses Not Expected to
Harm Bank Earnings," American Banker, vol. 147,
no. 129 (July 6, 1982).

gests that annual loan loss levels vary
considerably across companies.
Examination of the mean level of the
nonperforming loan ratio (ratio 2, table 1)
over time reveals that problem loans generally have increased over the 1980-81
interval, While 1982 nonperforming loan
data are not yet available for the companies in this sample, analysts expect this
upward trend to continue, with this ratio
being in the 3 percent to 5 percent range
by the fourth quarter of the year.4 Since
nonperforming loan levels tend to be
related to realized loan losses with some
lag, this finding suggests that net loan
charge offs might increase rather than
decrease in the future. Once again, the
standard deviations and ranges show
considerable variation in nonperforming
loan levels across banks.
While the ratios discussed here give
some indication of holding company loan
quality, it is possible, and perhaps more
appropriate, to look at other ratios in
which net charge offs and nonperforming
loans are related to various measures
that reflect the ability of banks to cover
actual and prospective loan losses.
The first line of defense for a bank or a
bank holding company against anticipated loan losses is the valuation reserve
for loan losses. These reserves exist
because banks have been permitted to
deduct amounts from taxable income for
prospective loan losses (the provision for
loan losses) in excess of their realized net
loan charge offs in any particular
year.5 At the end of the year, a banking
organization's net loan losses are
"charged" against its loan-loss reserves
rather than against its current earnings.
An organization's earnings thus remain
insulated from its loan losses, as long as
its net loan charge offs in any year are
4. See Norton, "Loan Losses Not Expected to
Harm Bank Earnings."
5. The annual change in a bank's loan-loss reserves
is the difference between its provision for loan
losses and its net charge offs. When the former
exceeds the latter, reserves increase and vice versa.

less than its total loan-loss reserves.6
This discussion suggests that net
charge offs should be compared not only
with a holding company's total volume of
loans but also with its reserves for loan
losses (ratio 3, table 1). Over the past
four years, loan-loss reserves in general
have been sufficient to absorb realized
loan losses. Like the net charge off ratio,
the mean value of net charge offs relative
to loan-loss reserves has not increased
steadily over time, but it was higher in
1982 than in the three previous years.
Again, a great deal of variation in this
ratio is apparent across holding companies in every year. This ratio is very
high for several institutions in anyone
year. This explains the larger size of the
mean relative to the median. However, in
1982 the minimum and maximum values
of this ratio are both above their respective levels in 1981, and the range is
narrower. This finding, along with the
decrease in the size of the standard deviation relative to the mean, suggests that
loan quality became a bigger problem for
many of the sample companies in 1982.
Examining net charge offs in relation to
a holding company provision for loan
losses (ratio 4, table 1) indicates whether
holding companies have been able to
effect a net increase in their loan-loss
reserves in any given year, despite their
charge offs. A company's loan-loss
reserves increase as long as this ratio is
less than 100 percent.
6. Because banks were permitted to charge a provision for loan loss against income in excess of actual
loan losses, there was an incentive to inflate this expense (and loan-loss reserves) to decrease their tax liability. To prevent this, gradually declining maximum
loan-loss reserves ratios (loan-loss reserves divided
by average loans) were established for banks by the
Tax Reform Act of 1969. However, the scheduled reo
duction for 1982 was postponed for one year by the
Economic Recovery Tax Act of 1981. The 1969 act
also stipulated that, beginning in 1988, permissible
bank loan-loss reserves ratios would depend on their
average actual loan-loss experience over the recent
past. For a discussion of bank loan-loss practices and
pertinent regulations, see Stuart A Schweitzer, "Bank
Loan Losses: A Fresh Perspective," Business Review,
Federal Reserve Bank ofPhiladelphia, September 1975.

Even though loan losses generally
increased after 1979, net charge offs have
remained below holding company provisions for loan losses. The mean value of
this ratio for the sample companies was
80.7 percent in 1980 and 1981, and it even
declined slightly in 1982. The median
value behaved similarly. Thus, most sample holding companies evidently were
able to boost their loan-loss reserves over
the 1979-82 interval, Again, considerable
variation in this ratio is apparent, but the
variation does not appear to be increasing much over time.
Loan-loss reserves are intended to absorb anticipated loan losses. If losses are
unexpectedly severe, a company then can
use its current earnings to absorb loan
losses. So-called loan coverage ratios indicate a company's ability to utilize its
earnings for this purpose. The mean and
median values of such a ratio (ratio 5,
table 1) have declined steadily since 1979.
However, earnings available to cover loan
losses at a typical holding company remain
five times greater than 1982 charge offs.
Equity capital is the final defense
against unusually large loan losses. In
ratios 6 and 7, net charge offs and nonperforming loans, respectively, are
divided by holding company equity. The
mean value of ratio 6 declined in 1981
compared with the two previous years,
but increased in 1982. Variability also
appears to have increased in 1982 relative to previous years. The mean value of
ratio 7 has increased over the 1980-81
interval, and it should be even higher in
1982 if estimates of nonperforming loan
levels prove correct. Since variability
remained relatively unchanged in 1981,
the increase in this mean from 1980 to
1981 seems to indicate that nonperforming loans rose at virtually all of the sample companies rather than simply being
much higher at only a few companies.
The larger means of these last two ratios
relative to their counterparts
(ratios 1
and 2, which have a loan-volume measure in the denominator) graphically illustrate the high degree of financial leverage

Table 2 Loan Quality Ratios vs.
Potential Determinants

Determinants

Net charge
offs/average
net loans, 1982

Standard deviation, quarterly
rate of return on share of
equity, 1980:IQ-1981:IVQ

0.29*

Net charge offs/average net
loans, 1981

0.52*

Nonperforming loans/average
net loans, 1981

0.46*

Percent change in net loans,

0.12

1981-80

Commercial and industrial loans/
average net loans, 1981

0.22

Real estate construction loans/
average net loans, 1981

0.31*

Real estate mortgage loans/
average net loans, 1981

-0.28*

Consumer loans/average net
loans, 1981

-0.13

Rate-sensitive loans'yaverage
net loans
Holding company total
assets, 1982
State unemployment rate
(average), 1982

0.30·
-0.14
0.21

* Significant at 5 percent level, two-tail test.
a. Rate-sensitive loans are loans with maturities
of less than one year plus floating-rate loans.
utilized by depository institutions, indicating why loan quality is of great concern to regulators, consumers, and the
business sector alike.

Measured Loan Quality
Each holding company's loan quality is
a product of several factors-its
preference for risk, its loan portfolio composition, and the state of the local economy,
among others. Correlating possible
explanatory variables with each holding
company's 1982 net charge off ratio helps
to identify the most important forces
influencing loan quality.
Companies that attempt to earn higher
returns by taking on more risk may experience higher loan losses. Several variables are used in table 2 as risk-posture
proxies-the
standard deviation of the
quarterly rate of return on a share of

Federal Reserve Bank of Cleveland
holding company equity, the 1981 net
charge off ratio, the 1981 nonperforming
loan ratio,_ and the percentage change in
total loans in 1981. All four of these variables are positively correlated with 1982
charge offs, the first three significantly.
Net charge off ratios also can be influenced by holding company loan composition. Total loans are divided into four
categories in the annual reports of holding companies-commercial
and industrial, real estate construction, real estate
mortgage, and consumer. Thus, four loan
composition ratios can be constructed by
dividing each subtotal by total loans. Both
the commercial and industrial loans and
the real estate construction loan ratios
are positively correlated with holding
company net charge offs. The real estate
mortgage loan and consumer loan ratios
are negatively correlated with holding
company loan losses. This finding is
somewhat surprising, as consumer loans
have been viewed as increasingly risky
since the 1979 changes in federal bankruptcy laws.
The rate sensitivity of a holding company's loan portfolio also can affect its
loan quality. The unprecedented
volatility
of interest rates in recent years has
exposed banking organizations to considerably more interest-rate risk than in
the past. Many organizations have
responded by transferring as much of the
increase in interest-rate risk as possible to
borrowers through the use of short-term
fixed-rate and floating-rate loans. However, because some borrowers might be
unable to deal with interest-rate risk, this
tactic may serve to increase a company's
credit risk while decreasing its exposure
to interest-rate changes. The positive,
significant correlation between the loan
quality ratio and the rate-sensitive loan
ratio suggests that credit risk was substituted for interest-rate risk. However, this
relationship might weaken in the future if
interest rates trend lower and exhibit
more stable behavior.
The extent of holding company diversification, both product line and geo-

Table 3 Loan Quality Ratios vs.
Measures of Performance
Loan quality ratios
Performance
measures

Net charge
Nonperforming
offs/average
loans/average
net loans, 1982 net loans, 1981

Percent change,
net interest
margin,1981-82
Return on average
assets, 1982
Rate of growth,
earningsper share,
1978-82
Marketprice per
share of equity/
earningsper share"

-0.05

-0.13

-OA1*

-0.17

-0.27*

-0.28*

-0.13

-0.18

* Significant t 5 percent level,two-tailtest.
a
a. Averageof year-end 1982and 1983:IQ
data.
graphic, could be related to a holding
company's loan quality. Such diversification should reduce charge offs. Holding
company size is used as a crude proxy for
both types of diversification. The size variable exhibits the anticipated indirect relationship to the net charge off ratio. However, the correlation is statistically weak.
The quality of holding company loans
should be related to the condition of the
local economy (which, of course, depends
on the national economy). The unemployment rate in the headquarters'
state
of each sample company was used as an
indicator of local economic conditions. As
expected, this variable was positively correlated with the net charge off ratio. The
implication of this finding is that the level
of holding company loan losses and nonperforming loans in the future will depend
critically on the timing and strength of the
incipient economic recovery.
Loan Quality and Bank Performance
The impact of loan quality levels on
holding company performance is of interest for several reasons. Sustained high
levels of loan losses and non performing
loans can negatively affect a company's
earnings, making it more difficult and/or
more expensive for organizations to
augment their capital positions over time

or borrow funds in national money
markets. Strong capital positions and the
ability to raise funds without paying
excessive risk premiums might be essential for survival in the future as deregulation proceeds and competition intensifies.
To obtain insight on this issue, the 1982
net charge off ratio and the 1981 nonperforming loan ratio were correlated with
several indicators of holding company
performance-percent
change in net
interest margin, return on assets, growth
in income per share, and market value
per share of equity relative to earnings
per share (see table 3). The latter performance measure is particularly useful
for analysis, because it reflects the value
that investors place on an institution's
accounting earnings.
The correlations confirm the intuitive
notion that deterioration in loan quality
adversely affects holding company performance. Specifically, higher loan loss
and nonperforming loan ratios are associated with smaller percentage increases
in net interest margins, lower return on
assets, slower growth in earnings per
share, and lower price-earnings ratios.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland,OH
44101

Conclusion
Net charge offs at bank holding companies increased sharply in 1982, after
declining in 1981. Despite the length and
severity of the recession, loan-loss levels
generally remain below the peaks reached
in the 1974-75 recession. Nonperforming loan levels have risen since 1979 and
are likely to trend higher in the 1982-83
period. Whether this rise in nonperforming loans will produce higher loan losses
depends on the course of economic activity. The data suggest that holding companies have the capability to endure
higher loan losses should they materialize.
The data also suggest that loan quality
affects holding company performance.
Thus, loan quality will have important
effects on the ability of holding companies
to raise funds in national money and capital markets, particularly now that banking
organizations will be required to disclose
more detailed information about their
problem loans. Funds availability and cost
may be the critical factors influencing a
holding company's prospects for survival
and growth in today's increasingly competitive financial environment.
BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Economic Commentary

ISSN0428-1276

Loan Quality of Bank Holding Companies
by Gary Whalen
Like most types of depository institutions, commercial banks operate with a
high degree of financial leverage; that is,
their equity typically is small relative to
their total assets. As a result, the loan
quality and solvency of commercial banks
are inextricably related. For this reason
banking regulators, who are charged with
preserving the safety and soundness of
the nation's banking system, are concerned with bank loan quality; businesses
and households, who supply banks with
investable funds, share these concerns.
Loan quality is largely a function of the
financial health of a bank's borrowers.
Because of the recession, disinflation,
persistently high interest rates, and heavy
corporate and consumer reliance on
debt, it has become increasingly difficult
for many classes of borrowers to repay
their bank loans. The resulting deterioration in loan quality at many banks is the
subject of this Economic Commentary,
which explores recent changes in loan
quality at a cross-section of 60 regional
bank holding companies located in 12
states. 1 The article identifies the factors
responsible for variations in loan quality
across holding companies and discusses
the impact of changes in loan quality.
Indicators
of Loan Quality
Two indicators of a holding company's
loan quality are used in this study-net

Address Correction
Requested:
Reserve Bank of Cleveland.Research

Please send corrected mailing label to the Federal
Department, P.O. Box 6387, Cleveland, OH 44101.

March 21, 1983

1. Companieswere drawn nonrandomlyfromthe
twelvestates in the study, as follows: labama,five;
A
Colorado,four; Florida,seven; Massachusetts,
three; Michigan,two; Missouri,four; NewJersey,
six; Ohio, four;Tennessee, three; Texas, six; Virginia,seven;and Wisconsin,nine. The analysisof
consolidatedholdingcompanydata presumes that
the fortuneof a typicalcompanyis primarilya function of the performanceof its bank affiliates.

loan charge offs and non performing
loans. Net charge offs are the total
amount of loans judged to be uncollectible in a given year, minus any recoveries
of loans previously charged off.2 Nonperforming loans, which include nonaccrual loans, renegotiated loans, and
loans with principal and/or interest payments contractually past due 90 days or
more, are a second indicator of loan
quality. Nonperforming loans imply that
there has been some deterioration in the
financial condition of the borrower.
Thus, total nonperforming loans give
some indication of future net loan charge
off levels. However, not all nonperforming loans are subsequently charged off.
More importantly, nonperforming loan
totals also provide insight on the shortrun earnings impact of problem loans.
Slower payback of principal and/or
interest payments on non performing
loans imply lower bank earnings.
Since net charge off and nonperforming loan levels increase with an institution's loan volume, it is necessary to
transform each indicator into an associated loan quality ratio-dividing
each
measure by a holding company's average
total loans-before
analyzing loan quality
across banks and/or over time. The
means, standard deviations, and ranges
of these ratios for the 60 sample companies since 1979 are shown in table 1. The
2. Recoveriesaverage 15to 22 percent of annual
gross loan charge offsat bank holdingcompanies.
The author is an economist with the Federal
Reserve Bank of Cleveland. Research assistance
was provided by June Gates.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

Federal Reserve Bank of Cleveland
holding company equity, the 1981 net
charge off ratio, the 1981 nonperforming
loan ratio,_ and the percentage change in
total loans in 1981. All four of these variables are positively correlated with 1982
charge offs, the first three significantly.
Net charge off ratios also can be influenced by holding company loan composition. Total loans are divided into four
categories in the annual reports of holding companies-commercial
and industrial, real estate construction, real estate
mortgage, and consumer. Thus, four loan
composition ratios can be constructed by
dividing each subtotal by total loans. Both
the commercial and industrial loans and
the real estate construction loan ratios
are positively correlated with holding
company net charge offs. The real estate
mortgage loan and consumer loan ratios
are negatively correlated with holding
company loan losses. This finding is
somewhat surprising, as consumer loans
have been viewed as increasingly risky
since the 1979 changes in federal bankruptcy laws.
The rate sensitivity of a holding company's loan portfolio also can affect its
loan quality. The unprecedented
volatility
of interest rates in recent years has
exposed banking organizations to considerably more interest-rate risk than in
the past. Many organizations have
responded by transferring as much of the
increase in interest-rate risk as possible to
borrowers through the use of short-term
fixed-rate and floating-rate loans. However, because some borrowers might be
unable to deal with interest-rate risk, this
tactic may serve to increase a company's
credit risk while decreasing its exposure
to interest-rate changes. The positive,
significant correlation between the loan
quality ratio and the rate-sensitive loan
ratio suggests that credit risk was substituted for interest-rate risk. However, this
relationship might weaken in the future if
interest rates trend lower and exhibit
more stable behavior.
The extent of holding company diversification, both product line and geo-

Table 3 Loan Quality Ratios vs.
Measures of Performance
Loan quality ratios
Performance
measures

Net charge
Nonperforming
offs/average
loans/average
net loans, 1982 net loans, 1981

Percent change,
net interest
margin,1981-82
Return on average
assets, 1982
Rate of growth,
earningsper share,
1978-82
Marketprice per
share of equity/
earningsper share"

-0.05

-0.13

-OA1*

-0.17

-0.27*

-0.28*

-0.13

-0.18

* Significant t 5 percent level,two-tailtest.
a
a. Averageof year-end 1982and 1983:IQ
data.
graphic, could be related to a holding
company's loan quality. Such diversification should reduce charge offs. Holding
company size is used as a crude proxy for
both types of diversification. The size variable exhibits the anticipated indirect relationship to the net charge off ratio. However, the correlation is statistically weak.
The quality of holding company loans
should be related to the condition of the
local economy (which, of course, depends
on the national economy). The unemployment rate in the headquarters'
state
of each sample company was used as an
indicator of local economic conditions. As
expected, this variable was positively correlated with the net charge off ratio. The
implication of this finding is that the level
of holding company loan losses and nonperforming loans in the future will depend
critically on the timing and strength of the
incipient economic recovery.
Loan Quality and Bank Performance
The impact of loan quality levels on
holding company performance is of interest for several reasons. Sustained high
levels of loan losses and non performing
loans can negatively affect a company's
earnings, making it more difficult and/or
more expensive for organizations to
augment their capital positions over time

or borrow funds in national money
markets. Strong capital positions and the
ability to raise funds without paying
excessive risk premiums might be essential for survival in the future as deregulation proceeds and competition intensifies.
To obtain insight on this issue, the 1982
net charge off ratio and the 1981 nonperforming loan ratio were correlated with
several indicators of holding company
performance-percent
change in net
interest margin, return on assets, growth
in income per share, and market value
per share of equity relative to earnings
per share (see table 3). The latter performance measure is particularly useful
for analysis, because it reflects the value
that investors place on an institution's
accounting earnings.
The correlations confirm the intuitive
notion that deterioration in loan quality
adversely affects holding company performance. Specifically, higher loan loss
and nonperforming loan ratios are associated with smaller percentage increases
in net interest margins, lower return on
assets, slower growth in earnings per
share, and lower price-earnings ratios.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland,OH
44101

Conclusion
Net charge offs at bank holding companies increased sharply in 1982, after
declining in 1981. Despite the length and
severity of the recession, loan-loss levels
generally remain below the peaks reached
in the 1974-75 recession. Nonperforming loan levels have risen since 1979 and
are likely to trend higher in the 1982-83
period. Whether this rise in nonperforming loans will produce higher loan losses
depends on the course of economic activity. The data suggest that holding companies have the capability to endure
higher loan losses should they materialize.
The data also suggest that loan quality
affects holding company performance.
Thus, loan quality will have important
effects on the ability of holding companies
to raise funds in national money and capital markets, particularly now that banking
organizations will be required to disclose
more detailed information about their
problem loans. Funds availability and cost
may be the critical factors influencing a
holding company's prospects for survival
and growth in today's increasingly competitive financial environment.
BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Economic Commentary

ISSN0428-1276

Loan Quality of Bank Holding Companies
by Gary Whalen
Like most types of depository institutions, commercial banks operate with a
high degree of financial leverage; that is,
their equity typically is small relative to
their total assets. As a result, the loan
quality and solvency of commercial banks
are inextricably related. For this reason
banking regulators, who are charged with
preserving the safety and soundness of
the nation's banking system, are concerned with bank loan quality; businesses
and households, who supply banks with
investable funds, share these concerns.
Loan quality is largely a function of the
financial health of a bank's borrowers.
Because of the recession, disinflation,
persistently high interest rates, and heavy
corporate and consumer reliance on
debt, it has become increasingly difficult
for many classes of borrowers to repay
their bank loans. The resulting deterioration in loan quality at many banks is the
subject of this Economic Commentary,
which explores recent changes in loan
quality at a cross-section of 60 regional
bank holding companies located in 12
states. 1 The article identifies the factors
responsible for variations in loan quality
across holding companies and discusses
the impact of changes in loan quality.
Indicators
of Loan Quality
Two indicators of a holding company's
loan quality are used in this study-net

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March 21, 1983

1. Companieswere drawn nonrandomlyfromthe
twelvestates in the study, as follows: labama,five;
A
Colorado,four; Florida,seven; Massachusetts,
three; Michigan,two; Missouri,four; NewJersey,
six; Ohio, four;Tennessee, three; Texas, six; Virginia,seven;and Wisconsin,nine. The analysisof
consolidatedholdingcompanydata presumes that
the fortuneof a typicalcompanyis primarilya function of the performanceof its bank affiliates.

loan charge offs and non performing
loans. Net charge offs are the total
amount of loans judged to be uncollectible in a given year, minus any recoveries
of loans previously charged off.2 Nonperforming loans, which include nonaccrual loans, renegotiated loans, and
loans with principal and/or interest payments contractually past due 90 days or
more, are a second indicator of loan
quality. Nonperforming loans imply that
there has been some deterioration in the
financial condition of the borrower.
Thus, total nonperforming loans give
some indication of future net loan charge
off levels. However, not all nonperforming loans are subsequently charged off.
More importantly, nonperforming loan
totals also provide insight on the shortrun earnings impact of problem loans.
Slower payback of principal and/or
interest payments on non performing
loans imply lower bank earnings.
Since net charge off and nonperforming loan levels increase with an institution's loan volume, it is necessary to
transform each indicator into an associated loan quality ratio-dividing
each
measure by a holding company's average
total loans-before
analyzing loan quality
across banks and/or over time. The
means, standard deviations, and ranges
of these ratios for the 60 sample companies since 1979 are shown in table 1. The
2. Recoveriesaverage 15to 22 percent of annual
gross loan charge offsat bank holdingcompanies.
The author is an economist with the Federal
Reserve Bank of Cleveland. Research assistance
was provided by June Gates.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.