The Banking Dilemma


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Here it is in a nutshell: profits rose to a 5 year high in 2011 but operating revenue fell for only the second time since 1938.  Why is that a problem?  Because most of the profits came from lower loan loss reserves, not from new loans.  Banks can't keep that up very long.  While those profits look good in the headline, they won't be sustained.  If you own a bank stock you need to look where its profits are being made.

Loan loss reserves are moneys set aside to cover future losses a bank may sustain.  For example, if a home mortgage goes into default, the bank takes the property, then resells it.  Many times that creates a loss, especially in these economic times.  That loss doesn't come from current earnings.  It's taken from the Loan Loss Reserve pool that every bank creates just for that purpose.

When banks have fewer loan losses, they start taking fewer loan loss reserves.  What would have gone into that reserve column goes into the profit column.  It's a great way to boost profits.  But banks can't do it forever.  They have to keep loan loss reserves at a level that reflects close to actual losses.  Once that level is reached, there won't be any added benefit from lowering loan loss reserves because it can't be done.  Furthermore, if losses start to mount again, loan loss reserves need to  increase to reflect current losses.  That means profits will be lower unless loan origination fees and interest income increase from making more loans.  In other words, operating revenues go up because more loans are made.

In 2011, all banks made net income of $119.5 billion, up $34 billion from full year 2010 earnings.  In the fourth quarter, banks made $26.3 billion compared to $4.9 billion in 2010's fourth period.  (All data from the FDIC report)   Most of the improvement in the earnings came from lower provisions for loan loss reserves.  Don't expect the same improvement in 2012 unless many more loans are made.

The fourth quarter did show increases in loan balances, to the tune of $130.1 billion more than in the fourth quarter of 2010.  There were also increases in second and third quarters, $64.4 billion and $21.8 billion respectively.  In the previous 11 quarters, loan balances declined.  FDIC acting chief Martin Gruenberg noted that loans to medium and large businesses increased in each of the last 6 quarters.

It was also reported that fewer U.S. banks are in financial distress, declining to 813 from 844 in the fourth quarter.  Assets of problem institutions fell to $319 billion from $339 billion.  Banks have been coming off the list because some banks failed while others made improvements, mostly through capital raises and asset sales.

Gruenberg did display some optimism.  2011 was the second full year of improving performance by the banking system.

Now the question is: will 2012 show further gains or have banks taken as much from their loan loss reserves as is prudent?  Investors owning bank stocks need to look at where earnings for their stocks are coming from.  Is it from fewer loan loss reserves or from operating earnings?  The stocks with the former may be candidates for sale while the ones with the latter are certain to perform even better as the economy improves.

- Ted Allrich
February 28, 2012

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Investing Ideas , Stocks

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Ted Allrich

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