Friday, July 23, 2010

Mixed Signals on Bank Reserve Policies: Real Profits Realized?

JULY 23, 2010

Banks Cite Improving Conditions in Loan-Loss Recalibration; Accounting Debate

By DAN FITZPATRICK, Wall Street Journal

First Horizon National Corp., a Memphis, Tenn.-based bank still exposed to housing problems, shocked Wall Street last week when it announced its first quarterly profit in more than two years.
What was its magic formula? It cut by 73% the cash set aside toward iffy loans. The reduction was almost entirely responsible for its return to the black.

"We wouldn't be decreasing reserves if we didn't feel that was a good thing to do," said Chief Financial Officer William Losch III, who noted First Horizon's reserve-to-loan cushion is still a healthy 4.55%.

Several regional banks in the Midwest and Southeast said Thursday that they made similar moves, reducing reserves in the second quarter. Cleveland-based KeyCorp reported its first quarterly profit in two years as the money it set aside for bad loans fell 72%. Columbus, Ohio-basedHuntington Bancshares cut its loan-loss provision by 53%, squeezing out a surprise profit of $48.8 million for the period. And McLean, Va.-based lender Capital One Financial Corp. slashed the amount applied to reserves by 23% as it recorded a profit of $608 million. The added cushion was about $1 billion less than the amount it charged off on bad loans.

At a time when revenues are slowing and loan balances are shrinking, banks across the U.S. are boosting net income by saving less for a rainy day. Some observers worry the aggressive moves could leave the banks exposed if the economy gets worse, because reserves act as a first line of defense against bad loans. Banks, however, say reductions are justified because credit conditions are improving, although reserve levels also are falling because banks are shrinking their loan portfolios.

Either way, this string of reserve reversals may stoke the debate over how best to account for bad loans. The process remains more art than science, and is further complicated by differing recommendations from regulators.

J.P. Morgan Chase & Co. Chief Executive James Dimon acknowledged a reserve lift, which contributed about a third of the bank's second-quarter profits, was little more than a temporary fix. "We don't consider that earnings," he said last week. "It means nothing."

Not all banks are rushing to release large amounts of reserves just yet, reflecting lingering concerns about the U.S. recovery. Winston-Salem, N.C.-based BB&T Corp on Thursday said it set aside just 7% less for bad loans in the second quarter of 2010 than it did in 2009. "We really want to be conservative," said BB&T CEO Kelly King on a conference call.

Banks typically use past loan performance and economic models when setting reserve levels, but certain regulators are pushing for changes in how banks arrive at those numbers. The Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency want banks to set aside money based on expected losses over time. Reserve levels across the industry are at a 62-year high, or 3.7% of total loans.

The Securities and Exchange Commission, on the other hand, has in the past asked banks to stick to generally accepted accounting principles when setting reserves and has slammed certain banks for overstating provisions and using fat reserves to pad earnings.

The SEC declined to comment. An FDIC representative said "the FDIC supports building strong reserves that buffer losses that arise in bad times."

In the late 1990s, the SEC questioned the loan-loss accounting used by Atlanta-based SunTrust Banks Inc., and the bank agreed to cut provisions it made over a three-year period by a combined $100 million.

SunTrust on Thursday was among the banks that got a boost from a drop in reserve levels. Its loss of $56 million narrowed from a loss of $164 million a year earlier, as the amount it set aside for bad loans dropped 31%.

SunTrust CEO James Wells said on a conference call that he hopes for more regulatory guidance on appropriate levels of reserves, acknowledging the differences between bank regulators and the SEC. It isn't clear, he indicated, which regulator's view will prevail. "At this point, it's a toss-up."

Analysts said bank regulators should have done more to encourage a build up of reserves before the recent crisis. John Dugan, head of Office of the Comptroller of the Currency, said banks were deterred from setting aside more when times were good because auditors want them to build reserves based on losses already incurred, as opposed to expected losses over the life of the loan.

"Banks would have been far better off if they could have had higher reserves coming into the crisis to absorb the losses that occurred," Mr. Dugan said.

The Financial Accounting Standards Board has asked for comment on a proposal that would require banks to base their reserves on expectations of losses instead of historical measures, said a FASB spokesman. FASB hasn't signed off on the proposal, the spokesman said.

Last August, the SEC told bank CFOs they needed to justify any differences for how banks are accounting for loan losses and warned about the use of reserves to manipulate earnings: "Where we believe a financial institution's financial statements are inconsistent" with generally accepted accounting principles, the agency said, "we will take appropriate action."

Write to Dan Fitzpatrick at