Banks' loan loss reserve

Business Week has a great article about how banks have increased earnings in 2004 by decreasing their reserves for loan losses. The loan loss researve should reflect economic conditions and the economy has become stronger over the last year and a half. However, BW suggests that the decreases in loan loss reserves are a bit more than ordinary, additionally when the economy does lose steam the loan loss researves will need to be boosted again and that will only hurt future earnings. The Business Week article discusses the case of Comerica that decreased its loan loss reserve and was able to increase quarterly earnings by $98M. Looking at the 10-Q we find the following:

		September 30,				December 31,				September 30,
(in millions, except share data)		2004				2003				2003
		(unaudited)								(unaudited)
ASSETS
Cash and due from banks		$	1,560			$	1,527			$	1,955
Short-term investments			5,055				4,013				4,805
Investment securities available-for-sale			4,198				4,489				5,086
Commercial loans			21,146				21,579				22,030
Real estate construction loans			3,276				3,397				3,496
Commercial mortgage loans			7,931				7,878				7,631
Residential mortgage loans			1,263				1,228				1,210
Consumer loans			2,722				2,610				2,501
Lease financing			1,260				1,301				1,289
International loans			2,117				2,309				2,478
Total loans			39,715				40,302				40,635
Less allowance for loan losses			(729	)			(803	)			(802	)
Net loans			38,986				39,499				39,833
Premises and equipment			399				374				368
Customers’ liability on acceptances outstanding			41				27				22
Accrued income and other assets			2,720				2,663				2,726
Total assets		$	52,959			$	52,592			$	54,795

Looking at the reserve rate it goes from 1.974% in 2003 to 1.836% in 2004. If Comerica had used the same reserve rate in 2004 that it had used in 2003 the allowancee would have been $784M instead of $729.

In addition, here is an interesting quote from the article:

Tinkering with loan-loss reserves also distorts the true quality of bank earnings. A dollar of earnings in a quarter when the provisions are being reduced isn't as valuable as one when they're the same or rising. "Everybody can play the loan-loss game to varying degrees, and the market is generally going to see through it," says Craig Woker, a bank analyst at Morningstar Inc.

But that's not so easy for those investors who aren't well-versed in the nitty-gritty of bank bookkeeping. Bove thinks that bank reserve accounting needs a major overhaul. "In reality, it is really nothing more than a bunch of accountants flipping coins and playing games," he says. For now, investors should realize that the gravy train of 2004 may soon grind to a halt.

Thequote touches on earnings management, ethics, earnings quality and how many in business currently view the accounting profession.