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Bank profits could hinge on bad-loan reserves

Mark Garrison Oct 11, 2012
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There could be a clearer picture of how the economy is affecting big banks Friday, when JPMorgan Chase and Wells Fargo report their earnings. But it’s possible the picture might not be crystal clear because banks can boost their profits by dipping into their reserves, the rainy day funds set up to cover loans that may go bad.

“Rainy day” hardly describes the financial crisis. It was a deluge, an endless monsoon season. Banks stashed piles of money in the crisis’s wake. But now, the weather is better, so banks are moving billions from the reserve into the profit column.

“After financial downturns, during which banks are forced to reserve more, they begin to release those reserves,” says Johns Hopkins business professor Yuval Bar-Or. “So there’s nothing unusual about that.”

Reserves can be huge. A Wall Street Journal analysis found that in the last four quarters, Bank of America got nearly half of its pretax income from its reserve. For Citigroup, reserve releases accounted for more than a third of its income before taxes. A hefty reserve is nice to have at a time when bank profits have been hurt by new regulations and low interest rates.

Banks are in a tricky place as far as how big their reserves should be. Regulators with opposing agendas keep an eye on the number. On one side is the Securities and Exchange Commission, prone to suspicion of swollen rainy day funds.

“The SEC is concerned about banks holding too many reserves because they could potentially release those to do what is perceived as manipulating earnings,” says University of Chicago economics professor and former Fed governor Randall Kroszner.

So for the rainy day fund, the SEC says, “C’mon, the weather’s fine. Stop hoarding all this cash.” It doesn’t want banks sitting on a pile of money they can shovel into an earnings report during lean times. But bank regulators are the pessimists toting hulking golf umbrellas. They worry about heavy rain returning, so they want banks with lots of emergency money.

Caught between opposing forces, it’s hard to get that reserve money right.

“How much ought to be in the loss reserve is much more art than science,” explains banking consultant Bert Ely. “That’s essentially trying to predict the future.”

And that kind of prognostication is definitely not a skill the banks have been known for lately.

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