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Improving Asset Quality Is a Positive Sign for the Banking Sector

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Updated

Allowance-to-loan ratio declines

According to the latest data released by the Federal Reserve on June 5, 2015, the ALLL (allowance for loan and lease losses) ratio for all US commercial banks declined to 1.28% of total loans for the week ended May 27. The ratio was 1.29% in the previous week.

Firm-wide, here’s how some top banks compared in terms of loan loss allowance to total loans in the first quarter of 2015:

  • J.P. Morgan (JPM) – 1.52%
  • Wells Fargo (WFC) – 1.51%
  • Citigroup (C) – 2.38%
  • Bank of America (BAC) – 1.57%

Together, these four banks form ~27% of the Financial Select Sector SPDR Fund (XLF).

Citigroup maintains a higher allowance due to its significant global operations. It forms ~7.2% of the iShares U.S. Financial Services ETF (IYG).

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The ratio is declining over the long term

All banks maintain loan loss allowances to cover estimated potential losses in their loan portfolios. As the aftereffects of the subprime crisis have subsided, the allowance for loan losses for the industry have exhibited a declining trend. The above graph shows the weekly ratio of ALLL to total loans for all US commercial banks.

Improvement in asset quality

Loans on which payments are past due for thirty days or more are considered delinquent. Such loans include loans still accruing interest as well as those in non-accrual status.

The delinquency rate has been declining across all loan categories since the financial crisis. Charge-offs, the value of loans removed from the books and written off against loss reserves, have also been declining.

As the asset quality improves, banks are setting aside less allowance for potential defaults. Improved asset quality means fewer charge-offs and higher profits for banks. The banking sector’s asset quality indicators are generally moving in the right direction.

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