Breakingviews - Bad-debt puzzle has simple answer: consumer credit

MasterCard credit cards are seen in this illustrative photograph taken in London December 8, 2010.

LONDON (Reuters Breakingviews) - Banks’ pandemic bad-debt charges paint a bewildering picture. JPMorgan Chief Executive Jamie Dimon set aside roughly $8 billion for dud credit in the first quarter, equivalent to over 3% of the U.S. group’s loans on an annualised basis. By contrast Deutsche Bank’s Christian Sewing increased the German lender’s bad-debt reserves by a piddling 500 million euros - just 0.4% of total lending.

One interpretation is that Deutsche, Royal Bank of Scotland, UBS and other loan-loss laggards are being nonchalant about the coronavirus crisis, or are less able to prepare for the worst. Delve deeper into balance sheets, however, and a more straightforward explanation is that the main cause for concern is exposure to consumer finance.

It’s difficult to compare lenders’ loan books. Most of them intermittently report exposures by sector and region, but don’t break down loans by country, counterparty or type of collateral. Two lenders with seemingly similar exposures to airlines and mortgages, for example, could actually have vastly different risk profiles. That makes it hard to judge whether provisions for bad debt adequately cover possible future losses. Accounting rules also vary. American banks are supposed to make provisions for expected losses over the lifetime of a loan, while their European counterparts need only do so when credit quality deteriorates. Governments have also responded to the coronavirus pandemic in different ways. Wage guarantee schemes, such as the one adopted in Britain, should help keep people in their jobs and, therefore, better able to pay their bills. Meanwhile, joblessness has soared in America. This matters, because banks implicitly have to take a view on the effectiveness of government responses when plugging economic forecasts into their loan-loss models.

It’s nonetheless possible to tease some sense from the jumble of loan-loss numbers. The first step is to look at each bank’s total stock of provisions for bad debts, not just the incremental amount it set aside in the last quarter. That’s important because some lenders, like Spain’s Banco Santander, have historically earmarked a bigger chunk of their earnings for possible losses, giving them a larger buffer going into the crisis.

The second step is to hone in on consumer finance, which was responsible for some of the biggest bad-debt charges at lenders like JPMorgan and Barclays. American banks report total credit-card loans outstanding every quarter. For Europeans like BNP Paribas and Santander, it’s a little trickier. Outstanding loans in the French bank’s consumer-focused “personal finance” division act as a decent proxy, as does the Spanish lender’s stock of consumer loans. However, these numbers include both unsecured and secured debt, such as motor finance.

The analysis reveals a clear pattern. The higher a bank’s concentration to unsecured consumer finance, the higher its total provisions as a percentage of total loans (see chart). There’s also a strong correlation between banks’ consumer finance exposures and the size of their first-quarter bad-debt charges. Lenders appear to be betting that coronavirus loan losses will be concentrated in consumer credit. One explanation for why UBS, Credit Suisse and Deutsche have set aside relatively little so far is because they barely dabble in this business.

The banks’ thinking is logical. A troubled borrower is more likely to stop paying interest on an unsecured loan, like a credit card, than risk losing their home by skipping mortgage payments. There’s also less for banks to recover from a default when the loan has no collateral.

Yet bad-debt risks could easily spread beyond consumer finance. Commercial real estate could face a brutal reckoning if white-collar workers in major cities decide not to return to the office when lockdowns lift. Governments will at some point have to wind down their stimulus measures, potentially leaving over-indebted small and medium-sized enterprises vulnerable. Mass unemployment would lead to increased mortgage defaults.

The financial crisis of 2008 also tells a cautionary tale. Though few banks had lent directly to U.S. subprime mortgage borrowers, many ended up suffering huge losses on securities backed by those loans. The solution to banks’ first-quarter bad debt puzzle turns out to be fairly simple. The next chapter may be anything but.


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