For the better part of 2012, I have complained that America's largest financial institutions were using loan loss reserves to artificially inflate what would otherwise be sub par earnings. The practice is so pervasive that one third of Citigroup's (C) second quarter earnings and one half of the company's third quarter earnings were derived from reducing the amount put aside for bad loans.
Similarly, 56% of Bank of America's (BAC) second quarter pre-tax profit, 27% of JPMorgan's (JPM) second quarter net income, and 10% of JPMorgan's most recent quarterly net income all came from loan loss reserve reductions. As I noted when JPMorgan reported, the $900 million reduction in loan loss reserves for the third quarter looks especially ridiculous considering non-performing loans actually rose during the period.
There are some who argue that this is nothing to worry about. After all, the loan loss reserve component of earnings is clearly spelled out in the "significant items" list of the firms' press releases so there is no attempt to hide anything and furthermore, it is quite reasonable for these firms to be reducing the amount set aside for bad loans as the housing market is improving. As it turns out, the U.S. Comptroller of the Currency disagrees.
The Wall Street Journal reported Monday that U.S. Comptroller Thomas Curry suggested the government may take action to force banks to keep provisions for losses at appropriate levels should the regulator deem banks' practices irresponsible. Specifically, Mr. Curry said the following:
"I remain very concerned that too many institutions are continuing to reduce provisions solely to boost earnings. We are watching reserves very closely, and we expect national banks and federal savings associations to maintain them at appropriate levels. We are ready to take action if and when it is needed."
The Journal article also notes that as of the year ended July 2012, fully 23% of the pretax income reported by the nation's four largest banks was directly due to releasing loan loss reserves.
The question shareholders should be asking themselves is: where are the earnings going to come from going forward? I recommend staying clear of big banks until the regulatory environment becomes less adversarial.