In the Sherlock Holmes story "Silver Blaze," the famous detective solves�the mysterious theft of a thoroughbred race horse because�the border collie which�guards�the barn fails to�sound the alarm.� This remarkable circumstance leads to only one conclusion: that the dog knew the perpetrator of the theft and thus "did nothing in the night."

In much the same fashion, current financial data for US banks presents�a remarkably placid picture.� The latest report from the FDIC on bank and thrift�performance in 2005�shows that loan default levels, while rising,�remain very low by historical�measures�and that the US has now experienced the longest ever period without a bank failure.� FDIC insured institutions reported record earnings in 2005, some $134 billion or almost 10% above 2004 levels.� Yet far from giving risk analysts confidence about the future, this rosy picture should be cause for concern.

For some months now, we have�pointed out that levels of bank loan defaults in the US�are so far below�ten-year average levels as to cause us to question the veracity of the�data.� Not surprisingly, with the release to the public of the fourth quantitative impact study, or QIS4,�the various US bank regulatory agencies have begun to articulate more fully the reasons why bank capital levels are shown to be falling under estimates prepared under�the Basel II proposal.� Could it be that the sub-normal bank loan default rates and the low levels of Expected Losses�generated by internal risk models used in the QIS 4 survey�are saying the same thing?

Although there remain a number of institution-specific factors that affected the results of the QIS4, the report seems to suggest that the "benign economic environment" engineered by the FOMC over�the past several years has allowed banks to produce far lower estimates of minimum capital levels that would be the case at a different point in the economic cycle.� Put another way, the last period of interest rate ease by the Federal Open Market Committee seems to have not only created a bubble in markets such as real estate, but has also badly�distorted the credit risk profiles of US banks.

A number of our channel contacts report that internal measures such as lending cost have, like actual default rates, been negative for a number of quarters, providing the appearance of risk-free returns in consumer mortgage lending.� This observation�seems to confirm the�Economic Capital and RAROC figures for the ten largest US bank and thrift�holding companies�which we released last week, but these results�should make the hair on the back of every credit manager's neck stand out straight.�

Is it "benign" for lenders like GoldenWest Financial (NYSE:GDW) or Washington Mutual (NYSE:WM) to�report virtually zero defaults over the past several years?� That is one of the major reasons�why the IRA Bank Monitor�spits out�such stellar�RAROCs for many of the top 12 bank holding companies�in the US,�as shown in the table below:

The IRA Bank Monitor -- Q3 2005

HOLDING COMPANY	RAROC (%)	BASEL II RATING	LOSS GIVEN DEFAULT (%)
BANK OF AMERICA	19.80	BB	76.8
JPMORGAN CHASE & CO.	2.20	BB	74.5
CITIGROUP INC.	5.35	BB	69.9
WACHOVIA CORPORATION	18.87	BBB	54.6
WELLS FARGO & COMPANY	36.97	BBB	72.6
WASHINGTON MUTUAL	92.25	A	74.3
U.S. BANCORP	51.98	BBB	69.3
SUNTRUST BANKS, INC.	40.95	BBB	63.3
ROYAL BANK OF SCOTLAND	51.29	BBB	76.5
NATIONAL CITY CORPORATION	72.93	BBB	58.8
HSBC HOLDINGS PLC	4.10	BB	67.9
GOLDENWEST FINANCIAL	159.11	AAA	35.3

RAROC = Risk Adjusted Return On Capital. Also known as Return On Economic Capital. Basel II Rating = Actual loan portfolio default rate expressed as bond rating equivalent using industry break points. Loss Given Default ("LGD") = percent loss after default per dollar lent.

Could it be that the excessive interest rate ease engineered by the�Fed under�Alan Greenspan�between 2000 and 2004�so badly distorted the behavior of US consumers, and the credit markets which serve them,�that current bank default rates are obscuring the true risks facing the US�banking sector?� More specifically, is accommodative Fed monetary policy the major factor behind lower capital levels suggested by the QIS4 survey?�

We believe that the answer to both of�these questions is "YES" and that risk managers need to balance their expectations regarding future losses accordingly.� Ponder, for example, how those RAROC's will look for the top three money center banks -- Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM) and Citigroup (NYSE:C) -- when consumer loan default experience reverts to the mean.�

The bank loan�default data dog, after all, is still not barking.

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