FRBSF Economic Letter 2018-02 | January 22, 2018 | Research from Federal Reserve Bank of San Francisco How Do Banks Cope with Loss? Rhys Bidder, John Krainer, and Adam Shapiro When lenders experience unexpected losses, the supply of credit to borrowers can be disrupted. Researchers and policymakers have long sought estimates of how the availability of loans changes following a shock. The sudden oil price decline in 2014 offers an opportunity to observe precisely how affected lenders altered their portfolios. Banks that were involved with oil and gas producers cut back on some types of lending—consistent with traditional views of bank behavior. However, they expanded other types of lending and asset holdings with a bias towards less risky securities. The financial crisis that began in 2007 emphasized the importance of a healthy banking system. As banks faced losses on their investments, they pulled back from their vital role as intermediaries between savers and borrowers. Companies consequently found it more difficult to obtain loans and cut back on their operations further, contributing to the weakness of the broader economy (Chodorow-Reich 2014). Understanding how banks behave following losses is therefore critically important to economists and policymakers. Indeed, under the post-crisis stress testing program, envisaging how banks cope with damaging events has become a core component of the regulatory framework. In this Economic Letter , we discuss our recent work (Bidder, Shapiro, and Krainer 2017) that investigates how banks responded to losses on their loans to oil and gas (O&G) extracting businesses following the dramatic decline in oil prices in 2014. We show that banks with high exposure to these companies subsequently shifted away from portfolio lending—loans kept on their balance sheet—and towards holdings of safe securities. Banks typically did not shrink the overall quantity of investments, as much of the existing banking literature would suggest (Peek and Rosengren 1997, Holmstrom and Tirole 1997, and Khwaja and Mian 2008, among others), but rather changed the composition. They reduced the risk on their balance sheets instead of shrinking them. The oil shock of 2014 The price of oil declined dramatically and unexpectedly in the second half of 2014. As the red line in Figure 1 shows, oil had been fluctuating around $100 per barrel for some time, and market expectations based on oil futures were for prices to remain around that level through the end of the year and beyond. However, prices fell precipitously, breaking through the level many oil producers needed to maintain profitability. This caused O&G firms to delay or cease payment on loans, as illustrated by the blue bars in Figure 1. The fraction of loans that were either past due, charged off, or in nonaccrual status climbed from 0.6% in mid-2014 to 10.4% in 2016.