Today's reserves could be tomorrow's profits for some banking companies, if the economy and regulators cooperate.
Heavy reserving has cut the industry's profits during the recession. But analysts say that financial giants like JPMorgan Chase & Co., Wells Fargo & Co. and Bank of America Corp. could book sizable gains by winding down their massive reserves in 2011 and 2012. Regional banks are not as likely to see such a bounce, though, because they tend to have lower reserves than the largest lenders and deeper problems in home and business lending.
For JPMorgan, Wells and B of A, the economy and regulators are the main potential roadblocks to reclaiming all or part of the collective $43 billion they've set aside in the last four quarters. Industry overseers have not spelled out the level of reserves they will expect banks to hold should the economy and industry stabilize.
The comptroller of the currency, for one, has advocated changing accounting rules to force banks to hold higher reserves in times of low volatility. The income that banks would be able to claw back from reserves is also tied to loan-loss projections, notoriously foggy even in the best of times.
"If the economy bottomed out and housing prices have bottomed and unemployment starts going down and these are established as trends … , these reserves will start to drop, and you'll see outsized earnings for a period of time," said Keith B. Davis, an analyst at Farr, Miller & Washington.
Banks may now be operating a bit ahead of the curve; though reserves are not actually dropping, they seem to be plateauing.
Jason Goldberg, an analyst at Barclays Capital, said that reserves at the 26 big banks he covers rose $7.5 billion in the third quarter, about half as much as in the first half. In percentage terms, "the pace of reserve build is definitely slowing," he said. "I think that's consistent with stabilization in consumer delinquency trends. Eventually you stop padding, and you draw them down."
Reserves cut directly into profits when rising but boost them when falling. On the way up, profits are steered into reserves through loan-loss provisions. On the way down, excess reserves may be reclassified as net income. Regulators tend to frown on this practice, however. Instead, banks let reserves run off by setting aside less for loan losses than they charge off. So losses are booked against reserves, whittling them. The mismatch of loss provisions to chargeoffs nevertheless inflates earnings by reducing credit costs.
"What you're doing is taking a smaller expense," said David Gibbons, a managing director at Promontory Financial Group.
Though Goldberg said he does not expect to see reserve drawdowns soon, others are more bullish.
Anthony Polini, an analyst at Raymond James & Associates, said reserves at the largest banks could peak next year and start falling by 2011, which would improve earnings at the most heavily reserved companies for several quarters.
Winding down reserves at JPMorgan Chase through 2012 could add $5 to $6 to earnings per share, he said; By comparison, the company has earned $1.50 per share during the first nine months of 2009. At Bank of America, the gain could be as much as $2 per share, he said; the company has earned 39 cents per share in the first three quarters this year.
JPMorgan has $31.5 billion in reserves, or 4.74% of retained loans. Bank of America's $35.8 billion equals 3.95% of loans and leases. During normal economic times, most banks' reserves hover around 1.25% to 1.5% of loans. Bringing reserves down to a normal level could create a surplus of $15 billion at JPMorgan alone, Polini said. "At least half of their allowance to loans is probably excess."
The potential size of an earnings bounce depends, of course, on how much capital regulators decide banks must keep in reserves after an economic rebound. Bank reserving has been a hot-button issue; in the late 1990s, the Securities and Exchange Commission cracked down on SunTrust Banks Inc. for allegedly overreserving to manage its earnings. Since then, the SEC has made banks prove their reserves reflect actual losses. This has forced banks to keep low reserves during prosperity, a policy critics say worsened the credit crisis.
Comptroller of the Currency John Dugan said in a speech last March that banks should be allowed to overreserve in good times, though there has been no hard action on the regulatory front since then to change reserving standards.
Mark Fitzgibbon, director of research at Sandler O'Neill & Partners LP, said banks will probably have to keep reserves elevated until the economy fully recovers. If the rules are not changed, he said, banks will drive down their reserves to prerecession levels in order to expand profits.
"For a period of time, the accounting industry and the regulators will be willing to let banks run with much higher reserve levels because the pain from the problem loans is so fresh in their minds," he said. "Over time, people tend to forget."