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Banks are in the business of using the funds provided by depositors to make loans and invest in securities. Lending entails assuming the risk that some loans won’t be repaid. Banks maintain loan loss reserves for this likelihood.

Basically, the loan loss reserve reflects management’s estimate of the losses inherent in a bank’s loan portfolio at a given moment of time. Banks charge off bad loans against the reserve rather than directly against earnings. For each bank report in Value Line’s Ratings & Reports, the loan loss reserve is shown at the bottom of the Asset/Liability box, on the left side of the page.

To adjust the loan loss reserve for increases in bad loans during a quarter or a year, banks make non-cash provisions to their loan loss reserves that, like other expenses, reduce earnings. In Ratings & Reports, the loan loss provision is shown on line eleven of the Statistical Array, in the center of each bank report page.
In a nutshell, loan loss provisions add to the reserve but reduce earnings. Charge-offs of bad loans reduce the reserve, and recoveries of loans that were written off in the past increase the reserve. Neither loan charge-offs nor recoveries directly affects earnings.   

Banks take into account the type of borrower in figuring how much to add to the loan loss reserve. For their larger loans, including most of their business, construction, and commercial real estate credits, they assign specific reserves to  loans. The allocations rely on management’s assessment of the borrower’s financial condition, the state of the economy, the current value of the collateral behind the loan, the loan structure, the industry of the borrower, and other factors, and are somewhat subjective. Moreover, the timing of when different banks charge off bad loans and build reserves also varies from bank to bank. 

Banks also add a general component to the loan loss reserve for pools of loans that share characteristics and are collectively evaluated using statistical estimates. Most consumer loans, which are generally charged off after they are delinquent for a set number of days, fall into this category.

The size of loan loss provisions tracks the economic cycle. During recessions, problem loans typically rise, as economic pressures mount and borrowers experience difficulty in meeting their financial obligations. In such times, banks make larger provisions to their loan loss reserves to absorb higher levels of loan losses. Of all the items on bank income statements, the loan loss provision has been among the most volatile over the past five years, rising sharply during the 2007-2009 recession. Fifth Third Bancorp (FITB), whose problem loans doubled in 2008,  made a total of $4.6 billion of provisions to its loan loss reserve that year, which nearly tripled the size of its reserve.

On the other hand, when economic activity strengthens, and consumers and businesses regain their financial footing, problem loans typically decline, and some of the loan loss reserve is no longer needed. In such times, banks often reduce the reserve by making loan loss provisions that don’t fully offset loans charged off within a given period. In response to improvement in its credit quality, Fifth Third reduced its loan loss reserve in 2010 by making quarterly loan loss provisions totaling $1.5 billion that didn’t fully offset its $2.3 billion of net loan losses that year. As economic activity in the U.S. ramps up modestly in 2011, most banks’ loan loss reserves will probably decline further.

In the past, some banks have occasionally made zero or negative provisions to their loan loss reserves (they added a portion of the provisions taken in past periods back to earnings). Following a few years of dramatic asset-quality improvement, Bank of Hawaii (BOH) reversed a small portion of its loan loss reserve in 2004.

It may surprise many investors that banks don’t build extra reserves for a possible rainy day. Under current accounting rules, banks need to justify additions to their loan loss reserves based on the condition of their loan portfolios at a point of time. Although bank regulators want banks to have strong reserves, banks need to avoid managing earnings, that is, using surplus reserves to bolster earnings in tough times, which would raise quality-of-earnings issues with investors.

Back in 1998, the Securities And Exchange Commission became concerned that some banks were keeping excess reserves. Following a review by the SEC that year, SunTrust Banks (STI) reduced its loan loss provisions for the 1994-1996 period by $100 million and restated its earnings. Since then, there has been occasional discussion regarding the advantages and disadvantages of the current practice of reserving for probable loan losses (which results in wide swings in loan loss provisions and earnings over the economic cycle) as opposed to building up the reserve in good times and drawing down reserves in tough times (which might result in a smoother earnings trajectory).

Under current accounting practices, banks tend to add the least to their loan loss reserves when business activity is the strongest, which may result in earnings being overstated. Some in the industry have pointed out that, in the past, banks have relaxed lending standards in good times, so it’s appropriate that they build up loan loss reserves then. But we don’t currently see any signs that the rules regarding loan loss reserves are likely to change. 
 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.