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The February 3 Wall Street Journal has a story reporting that large U.S. banks are running out of excess reserves to take into income. That process of taking excess reserves into income, the Journal reports, has accounted for up to 25% of the recent earnings at such banks.

This report requires both some explanation and some expansion. First, the explanation:

Under standard accounting rules (GAAP), banks must establish an accounting entry called the Allowance for Loan and Lease Losses (ALLL). This accounting entry is required to be an amount considered adequate to cover estimated losses inherent in the current portfolio of loans and leases. The ALLL often is referred to as a "reserve" for loan losses. It is what the Journal story is discussing. (Banks do not establish reserves for possible losses on securities that they own because the possibility of losses on securities is supposed to be captured by the market value of the securities.)

The accounting literature also says "The allowance is an estimate based on subjective judgment and is difficult to audit." That statement should emphasize to investors that this amount is very much an "estimate."

When a bank takes a loss on a loan, that loss is deducted from the ALLL. The loss itself does not go through the bank's income statement. Instead, the ALLL is reevaluated at the end of each accounting period, and if it is found to be inadequate (after being reduced by the losses taken during the period), then it is added to-and the amount added to the ALLL is deducted from the bank's earnings. Conversely, if the ALLL is found to exceed the amount currently deemed needed, it is reduced by that excess, and the excess is taken into current earnings. That is what the banks have been doing as the economy has improved. Doing so is quite legal.

But in bad times, the ALLL is always inadequate, and the required additions to it always reduce earnings very substantially.

The way that banks must account for "impaired loans" exaggerates the required changes in the ALLL in bad times. Basically, once a loan has become impaired (usually meaning that it is not being repaid in accordance with its original terms), it has to be valued at the market value of its collateral rather than being carried at cost (less its implied part of the ALLL). The market value is supposed to demonstrate a fair estimate of the eventual loss that the bank will suffer. In down markets, these rules are likely to result in pessimistic forecasts of recoveries. This often leads to large additions to the ALLL (and therefore large P&L losses and capital decreases) in times of significant stress.

Here is the expansion:

Although a conservatively run bank should want to err on the conservative side by establishing and maintaining plentiful loan loss reserves, in the late 1990s and early 2000s, the SEC put pressure on banks not to establish "excessive" reserves. Establishing "excessive reserves" was said to be "managing earnings" - that is, trying to smooth out earnings from period to period - a practice that the SEC deemed misleading to investors in publicly owned banks. Unfortunately, many banks, forced to follow the SEC's dictates, had, as a consequence, inadequate reserves when the bad times came in 2008-2010. In effect, the SEC had contributed to the banking industry's losses in bad times by forcing banks to reduce their reserves. The SEC thus made banks more procyclical.

In my judgment, the SEC failed to understand that the purpose of the ALLL is to smooth earnings from period to period. Its purpose is to take reserves in the good times to cushion the losses that any banker should know will follow in the bad times. But the SEC has not changed its stance, and therefore the large banks are doing what is required by taking the "excess reserves" back into income as the economy improves. The only problem with that is that the reserves will be inadequate when the economy next turns downward, and additions to the ALLL will hit bank earnings hard again.

For these reasons, if the large banks are coming to the end of their ability to pump up current earnings by taking excess reserves back into income, then they also are in a position where in the next economic downturn, their earnings will suffer not only from whatever the effects of the downturn are, but also from the effects of having inadequate reserves for loan losses. You can blame the SEC as much as the banks for this, but it is the way the accounting system now works.

This situation impacts all the major lending banks, including Bank of America (NYSE:BAC), Citi (NYSE:C), JPMorgan Chase (NYSE:JPM), and Wells Fargo (NYSE:WFC), as well as super regionals like Suntrust (NYSE:STI) and Fifth Third (NASDAQ:FITB). It does not have a major impact on the processing banks, like Bank of New York Mellon (NYSE:BK) and State Street (NYSE:STT), or major trust banks like Northern Trust (NASDAQ:NTRS). For the impacted banks, it means that long-term earnings, through the business cycle, are likely to be substantially lower than the apparent earnings in good economic times. In effect, by following the SEC's policies, the lending banks have been borrowing earnings from the future and painting a rosier current picture than is warranted by experience.

Source: The Bank Reserves Cookie Jar Is Close To Empty