Banks Running Out of Ways to Make Up for Weak Revenue

The years of boosting profit by drawing down loan-loss reserves may be over.

Loan-loss provisions appear to have finally hit bottom after several years of steady declines. The average fourth-quarter provision — and the ratio of provisions to average loans — was flat at small and midsize banks compared to a quarter earlier, based on preliminary analysis by Keefe, Bruyette & Woods. Reserve releases, which have padded banks' earnings for more than five years, also stalled.

"The ability to reduce reserve levels is ending," said Frederick Cannon, research director for Keefe, Bruyette & Woods. "The combination of loan growth and reserve releases has gotten to the point where [reserves] can't be reduced any further."

The timing couldn't be worse for banks. Management teams, which are also dealing with an unexpected rise in noninterest expenses and lower yields on originations, will be under intense pressure to boost revenue in coming quarters. Keefe, Bruyette & Woods, for instance, lowered its 2015 earnings-growth estimates to 7% from 10%.

Rising provisions "will hurt earnings now more than at other points" in recent history, said Jeff Davis, managing director of the financial institutions group at Mercer Capital. "There is less revenue to absorb a pick-up in provisioning unless we see the Fed raise short-term interest rates."

Bankers, meanwhile, are keenly aware that they are dealing with one less lever to boost the bottom line.

"The era of substantial reserve releases or negative provisions has probably come to an end for the time being," Doyle Arnold, chief financial officer of Zions Bancorp in Salt Lake City, said during a Jan. 26 conference call to discuss quarterly results.

Aggregate loan-loss reserves at commercial banks, which peaked in early 2010 at more than $245 billion, fell to less than $115 billion at the end of September, according to data from the Federal Reserve Board.

The swing in provisioning has been especially dramatic for banks that had benefited from reserve releases, a boon that is now "fading into the past," rating agency DBRS wrote in an industry report issued Tuesday.

While reserves are declining, they are unlikely to go as low as the $68 billion of late 2006. Increased lending, a bright spot in the fourth quarter and an integral component of revenue growth, will force banks to add to loan-loss allowances. Loan books rose 8% from the third quarter, and 11% from a year earlier, at banks covered by Keefe, Bruyette & Woods.

Strong loan growth has "slowed the pace of reserve releases and resulted in a relatively stable" loan-loss provision compared to the third quarter, the research team at DBRS wrote.

A significant decline in provisions would likely face resistance from regulators, which have been pushing for higher reserves.

Comptroller of the Currency Thomas Curry has long advocated for higher provisioning, and his agency has been warning banks about the risks of having inadequate reserves. The OCC's latest risk report noted that banks are "lowering their underwriting standards without corresponding increases in allowances for loan and lease loss balances."

The Financial Accounting Standards Board is also expected to release a new accounting rule this year that would require banks to post higher reserves.

While loose underwriting may eventually hurt banks, credit quality for now continues to improve. Just 1% of bank assets were nonperforming in the fourth quarter, down 34 basis points from a year earlier, based on Keefe, Bruyette & Woods' report. Small and midsize banks have displayed particularly strong credit.

Granted, some banks are continuing to unlock earnings by releasing loan-loss reserves, including Independent Bank in Ionia, Mich., which benefited from a $1.1 million negative provision in the fourth quarter. But even those banks know that opportunities to tap the reserve are dwindling.

"I still think there is possibly room [for reserve releases], although you know it's not going to be there forever," Rob Shuster, the $2.2 billion-asset company's chief financial officer, said during a Jan. 23 conference call to discuss quarterly results. "So the timeframe for that probably is starting to get to the end... before you really get back to normalized provisioning levels."

Paul Davis and Jackie Stewart contributed to this story.