Skeptics Question Banks’ Bottom Lines

Some banks cheer an improvement to their bottom lines, but a debate is brewing over the calculations used to get there.

Bank of America and Wells Fargo reported profit rises in the fourth quarter, but some banking experts are concerned that Wall Street firms are quickly depleting a crucial type of rainy day fund.

As the economy has improved, banks have reduced how much money they set aside each quarter to build up the financial cushions that they must maintain to absorb potential losses from bad loans. Adding to the buffer, known as the loan loss reserve, is an expense that comes out of profits. Cutting back on this expense has been a huge lift to big banks’ bottom lines for many months. But the practice is also becoming a concern to regulators. The Office of the Comptroller of the Currency, for instance, warned the industry last year that bank earnings should not become dependent on the help they get from adding less to their reserves.

“You almost kind of have a tug of war going on,” said Jason Goldberg, an analyst with Barclays.

On Tuesday, Wells Fargo reported profit of $22 billion in 2013 and disclosed it had set aside nearly $5 billion less in loan loss reserves last year than it did in 2012. On Wednesday, Bank of America reported profit of $11 billion last year, and said it had set aside about $4.6 billion less in 2013 than it had in 2012.

The banks contend that the drop in bad loan expense is justified because their losses from bad loans, called charge-offs, are declining. “We have seen a dramatic reduction in charge-offs over the past couple of years as credit quality has improved across all of our portfolios, and we are adjusting our reserves accordingly,” a Bank of America spokesman said.

The comptroller commented on the lower bad loan expenses in a report last year. It noted that the largest banks had reduced the amounts they added to their reserves by 29 percent in the 12 months through June 2013.

Regulators keep a close eye on reserves because they want them to be big enough to absorb losses. Right now, with the economy picking up, and banks making fewer risky loans than before the financial crisis, banking analysts do not expect banks to become overwhelmed with bad loans. Still, like all rainy day funds, they have to be sufficient to cover even unexpected and potentially severe losses.

Analysts have different ways of assessing the strength of a bank’s loan loss reserve. For instance, they compare the reserve with a bank’s nonperforming loans, which are loans that show signs that they may not be repaid in full. Bank of America’s reserve, for example, exceeded its nonperforming loans by a small margin at the end of 2013. That margin was only slightly smaller than it was at the end of 2012.

Having to contribute less to those reserves is one of the reasons that Wall Street stocks have been on fire in 2013. “Maybe some banks are already getting that artificial boost,” said Gerard Cassidy, an analyst with RBC Capital Markets. “The market doesn’t discriminate as much as people would think.”

Still, the comptroller is worried that banks may not be fully recognizing problems brewing in their loan portfolio as they add less to their reserves. “The pace and magnitude of releases from allowance for loan and lease losses compared with underlying credit trends reveal a growing disconnect,” the regulators said in the report.

Peter Eavis contributed reporting.