Banks are now providing greater credit limits to card holders without the card holder making a request for more credit. Sounds to me like banks are on the race to the bottom to show the biggest earnings. Card holders who have maxed out their cards will likely spend more money that they don’t have and the banks will “show” earnings on the additional credit being extended. Sounds good right?!
There are some significant downsides to this easy credit program.
Banks create reserves to estimate the amount of loans that will not be paid back and credit cards are loans. So they are thinking in advance to deal with these regular events that occur. The reserve is an estimate and it is an expense taken each quarter. Therefore, the reserve amount effects their reported earnings.
The amount reserved for unpaid credit cards tends to get established on the lower side of things at this point of the economic cycle. This is because more favorable recent experiences are used to calculate the reserve amount and there is P&L pressure to beef up the bank’s earnings. Also, expanded credit offers new sources of income to increase their bottom line. The better the bottom line, the better they look compared to other banks. Those short-term earnings also are the basis of management bonuses!
It all sounds fine and dandy till credit card borrowers start to default when the economy rolls over. The banks will take the defaults against the reserves, but since they were trying to juice their profits, they’ll likely find that reserves were insufficient. The amount that exceeds the reserve will hit their income. When the “sh_t hits the fan”, the excessive amount can be much greater than the amount reserved for.
This whole scenario indicates to me another fault line in the economy. Add tons of bonds being floated, weak debt covenants, small credit spreads for low quality bonds, the rush into the bond sector and things are looking a little shaky.
I think of this as like playing Jenga. Everything is fine...until someone moves that final block!
