The Securities and Exchange Commission is reviewing the way SunTrust manages its reserves for potential loan losses. What, if anything, do we make of this investigation, especially with SunTrust's reputation for being "conservative"?

First, the SEC attempts to do good by focusing on disclosures and transparency, among other things. Disclosure means making sure investors have enough information to make informed decisions. Transparency has to do with the clarity and quality of that information. Opaque data are not what investors need, nor what the SEC wants disclosed.

One way to look at the issue is to think of a bank's loan-loss reserve as the water level in a bathtub, where the level reflects the reserves needed to cover future loan losses. The level, which is the key variable, can be raised by turning on a spigot labeled "provision for loan loss." This provision is a discretionary, noncash outlay that flows into the loan- loss reserve account on a bank's balance sheet. Loan-loss reserves, also called the allowance for loan and lease losses, is a contra-asset account deducted from gross loans to get net loans.

When a bank charges off bad loans because borrowers can't or won't repay, reserves go down the drain, and the water level in the tub falls. Through collections, however, recoveries are made on some of these bad loans. Thus, only net loan losses go down the drain and deplete the level of reserve.

To recap, when loans are charged off as losses, they deplete the loan- loss reserve; the provision for loan loss is an inflow that augments the stock or level or reserve. The periodic provision (usually quarterly) is an important variable, because it is subject to managerial discretion. Since setting the loan-loss reserve is part art and part science, it is watched closely by stock analysts, investors, auditors, bank regulators, and the SEC.

Because the provision for loan loss is subject to managerial discretion, it can be used to manipulate reported earnings to make them look smaller than they actually are. The SEC is concerned about this, because variability of earnings is a key measure of risk for any business, and risk, of course, affects value. A bank can smooth its reported earnings by using its provision for loan loss judiciously. When times are good and earnings are up, the bank over-reserves and reports lower earnings; when times are bad and earnings are down, the bank under-reserves and reports earnings higher than it could have without prior over-reserving. The overall result is a smoother earnings pattern.

The sinister view of this is that the bank is manipulating its earnings to enhance shareholder value. An alternative view is that the bank is behaving like the hardworking squirrel that stores nuts for the winter. It certainly makes sense to save for a rainy day when the weather is good.

This causes difficulty for anyone who focuses on accounting earnings. Richard Breeded, a former chairman of the SEC, said banks' financial statements should have "Once Upon a Time" stamped on them. To the extent that the SEC is trying to make banks' accounting earnings less of a fairy tale and more reflective of real earnings, it is to be applauded.

Usually, however, chronic under-reserving concerns bank regulators and the SEC the most, because this practice overstates a bank's earnings and capital. If a bank over-reserves, it understates earnings and capital. Because stock markets value high earnings and strong capital positions, it is difficult to make a compelling case for over-reserving, smoother earnings notwithstanding. If bankers do a better job of matching reported earnings with economic or real income, the divergence between book and market values of loans will be reduced. Since a bank's earning assets are dominated by loans, loan quality is a critical determinant of a bank's earnings and net worth.

Under- and over-reserving must be judged relative to the overall quality of a bank's loan portfolio. The most serious case is a bank with lots of bad loans that is under-reserving. Since SunTrust has a reputation for being conservately managed and having a strong loan portfolio, the SEC's investigation seems to be much ado about nothing, especially since SunTrust's reserve-to-loan ratio of 1.8-to-1.9% is not out of line with its peers.

Nevertheless, SunTrust has recognized that it needs to be more aggressive, as witnessed by its pending merger with Crestar and its recent move into investment banking via its purchase of Equitable Securities. These moves suggest that SunTrust has recognized that being known as "conservative" and "Coca Cola's bank," which have been good to SunTrust in the past, may not be good enough in the dynamic financial services industry of the next millennium.

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