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I strongly believe that for the next few quarters, financial institutions should build their balance sheets to the strongest possible positions in capital and liquidity and reserves. This is the logical tactic given the regulatory uncertainties paired with enormous demand potential as the credit and business cycles turn. Releasing reserves make no sense to me. First a snapshot of some recent selected data.

Reserve Release

3Q2012

4Q2012e

BAC

2.3b

1.3b

BBT

61m

40m

BKU

61M

40M

C

1.5b

0.6b

CMA

21m

10m

FHN

25m

FITB

91m

80m

HBAN

68m

35m

JPM

981m

.8b

KEY

25m

MTB

-4m

PNC

100m

100m

RF

229m

150m

STI

35m

USB

50m

50m

WFC

300m

300m

Data from O'Conner and Rochester 'Bank Cheat Sheets' .DB.December 14

This pattern of maintaining a steady release of reserves, fully substantiated in the notes, goes back many quarters. The reserve releases represent more than a 'one off' calculation. A bank releasing reserves is, IMHO, making a statement about the future. Essentially 'we do not need these reserves'. I thought I would ask "why?"

I believe the quote is attributed to Henny Youngman: 'Compared to what?' Obviously these are large numbers and relatively meaningless alone. Until we sort out an algorithmic analysis, we have to talk about the management philosophy behind three (or more) years where earnings are so strongly influenced by accounting rules and specifically large reserve releases. But first, where do we look for a connection in the operating statements?

Certainly not the composition of stated earnings, which are currently loaded with gains and losses we used to call 'one time'. (from my notes: CVA, CCAR costs, DVA, debt redemption, litigation charges, merger costs, mortgage putbacks, private equity gains, repositioning charges, securities gains are noted in multiple statements… plus unique items for individual banks)

3Q12EPS

4Q12 EPS

% Δ

Reported Revenue

Q/Q Δ

Actual

Est.

2Q2012

3Q2012

4Q2012e

BAC

0

0.2

18%

-1%

-7%

4%

BBT

0.66

0.7

2%

5%

1%

1%

BKU

0.44

0.43

15%

-4%

-1%

3%

C

0.97

1.04

13%

-8%

23%

35%

CMA

0.64

0.65

0%

-1%

-3%

2%

FHN

0.19

0.18

10%

11%

2%

0%

FITB

0.38

0.41

3%

-6%

0%

2%

HBAN

0.17

0.17

1%

-3%

1%

2%

JPM

1.2

1.22

0%

14%

13%

7%

KEY

0.21

0.22

5%

0%

9%

8%

MTB

1.84

2.16

3%

4%

7%

0%

PNC

1.61

1.59

8%

-3%

12%

3%

RF

0.2

0.2

1%

0%

0%

2%

STI

2.02

0.62

7%

1%

71%

39%

TCB

0.17

0.19

22%

10%

0%

3%

USB

0.74

0.75

1%

3%

2%

1%

WFC

0.87

0.9

2%

-2%

0%

2%

Data from O'Conner and Rochester 'Bank Cheat Sheets' .DB.December 14

Perhaps if we look at the direction of assets and provisions and revenues, it will give us an insight into the trends that drive bank management to continue to manage the impairment calculation process so it leads to continued reserve releases. Please don't be shocked, but the process leading to classification and provisioning is a bit like sausage making. From the underwriting to the structures, banks have a toolkit down at the business level to steer trends in the direction they wish to report (auditors included).

LLP Expense Q/Q Δ

Avg Loans

Q/Q Δ

2Q2012

3Q2012

4Q2012e

2Q12

3Q12

4Q2012e

BAC

27%

0%

3%

1.60%

-1.20%

0.50%

BBT

-5%

-11%

11%

1.20%

3.40%

1.70%

BKU

69%

134%

13%

12.60%

6.30%

6.90%

C

-7%

-4%

8%

0.10%

1.20%

0.30%

CMA

14%

16%

37%

2.30%

0.90%

1.10%

FHN

88%

167%

72%

0.50%

2.80%

0.70%

FITB

22%

-8%

4%

1.30%

0.40%

1.50%

HBAN

6%

1%

13%

1.40%

-2.60%

1.90%

JPM

71%

736%

43%

0.00%

-0.30%

1.40%

KEY

50%

419%

58%

2.20%

2.40%

1.90%

MTB

22%

-23%

1%

0.60%

2.60%

2.00%

PNC

38%

-11%

34%

0.70%

1.60%

2.00%

RF

78%

27%

65%

3.80%

-1.30%

0.70%

STI

-5%

50%

44%

1.90%

0.60%

1.10%

TCB

11%

78%

55%

0.00%

0.10%

2.60%

USB

-2%

4%

11%

1.30%

1.30%

WFC

10%

-12%

3%

1.10%

1.30%

All data from the analysis of the team at Deutsche Bank and the FDIC

Loans, loss expense, reported revenue and EPS are moving at a seeming random pattern due to all the accounting nuances positive and negative. I have wasted a lot of time looking for a fit, but there seem to be no statistical driving forces… so we have to look to the management philosophy of the bank (or insurance company) which continues to release reserves. Skeptics may insist that releases are for shareholder value, but the equity markets also pay attention to the business environment and fundamentals, no matter how much the traders seem to dominate. Has the equity price benefited? Is there a Jones effect? Is there a reputation effect from releasing reserves? I have not yet discovered any.

Theoreticians can discuss countercyclicality as much as they wish, but the maturity of the credit cycle allows a choice between keeping provisions in place or dramatically reducing reserves.

The data below is from the FDIC and is for all commercial banks. The industry is showing a sharp reversion to historical provisioning patterns, yet the releasing of reserves is unprecedented.

(click to enlarge)

Management may well be assuming that they can raise capital going forward at a lower cost than today, or that the demands for stronger balance sheet are less than the need for rosy reported earnings. Most management commentary on future capital management seems to focus on dividends and repurchases, without challenging the continued reserve releases. The skeptic in me feels they don't care anymore about the integrity of the reported earnings and have surrendered to the accountants. If we have to do the work on these companies, extra effort is required to uncover the core earnings.

What is the future business environment? The current set of alternative futures is a combination of uncertainties from the regulators and enormous opportunity for banks as the business cycle and the credit cycle both turn - two scenarios which demand a lot of capital . As much as ever, the 'fortress balance sheet' strategy makes sense.

I prefer to look for indications of a financial institution that is serious about fortifying its balance sheet. You have to follow the entrails in the notes and look for the words 'on top of' or 'buffer'. There is precedent for banks to create their own buffers for business reasons. Any other hints are certainly welcome, but senior management commentary will help us understand what they are thinking. I will hope for actual evidence that management is building their fortress, and not just talking about it.

Source: Reserve Releases At Banks: More Scrutiny Required. What Are They Thinking?