The reduction in reserve releases has become a recurrent feature for bank earnings every quarter. This quarter was no different, with banks reducing their reserves for loans gone sour, which also has a significant positive impact on earnings.
What Are Reserve Releases?
Reserve releases are the cuts that banks make in the excess cash held to cover for losses incurred from bad loans. Such losses occur when banks are forced to write off loans which they believe cannot be recovered.
A reduction in the amount of reserves occurs when a bank writes off a larger amount of bad loans than the amount that it adds to its reserves. Banks are able to make such reductions primarily due to accounting guidelines relating to corporate governance which require banks to release such reserves at a time when they do not expect to need them.
Quantum of Reserve Releases
All the large U.S. banks have been benefited by reserve releases. JPMorgan Chase & Co. (JPM) and Wells Fargo & Company (WFC) have both grown their fourth quarter net income using reserve releases. Compared to the year ago quarter figure of $888 million, J.P Morgan’s reserves set aside for covering bad debt increased to $1.3 billion in the fourth quarter.
Similarly, Wells Fargo increased its reserve releases to $600 million from the $250 million figure recorded a year earlier. Bank of America Corp. (BAC) also benefited from reserve releases of $1.2 billion, growing its fourth quarter earnings more than a billion over the last quarter.
Impact on Earnings
The reason why reserve releases continue to make news is the extent of the impact they have on earnings. Wells Fargo’s experienced a fall in the top line, owing to lower non-interest income. Revenues for the year ended 2013 were $83.8 billion, which marked a year-over-year decrease of 2.7%.
For JP Morgan, managed net revenue of $24.1 billion in the quarter was down 1% from the year-ago quarter. Managed non-interest revenues were flat compared to the year-ago while net interest income fell 2% year over year to $11.1 billion. Though in this case, the top line remained steady, it is easy to conclude that in both cases, reserve releases have made a significant difference.
Citigroup Inc. (C) was one of the banks which posted disappointing results despite significant reserve releases. For fourth-quarter 2013, earnings per share came in at 82 cents, lagging the Zacks Consensus Estimate of 95 cents. Revenues came in at $17.8 billion for the quarter, down 1% from the prior-year quarter. This despite an increase in reserve releases to $670 million, compared to the figure of $91 million for the same period last year.
Pros and Cons
The critics of reserve releases claim that they serve to deflect from the actual performance of the bank. The fact that they make up a large portion of earnings fortifies the argument that they hide systemic weaknesses. Around 31% of JPM’s earnings last year and 10% of WFC’s earnings can be attributed to loan-loss reserves.
The contrarian view is that the reduction in such reserves releases real money for banks. This is perfectly justified since a resurgent economy and higher credit quality no longer require them to maintain a large amount of reserves.
In Conclusion
As the economy stabilises and credit conditions return to pre-crisis levels, the extent of reserve releases have been falling. Reserve releases have declined from the third quarter for both Wells Fargo and J.P Morgan. For the former, the figure has fallen from $900 million to $600 million and for the latter form $1.8 billion to $1.3 billion.
It seems that though the amount of reserve releases may continue to remain significant through the year. However, several market watchers believe that this year may be a turning point and releases will continue to decline. Banks can then go on to focus on what is clearly a bigger issue, performance.
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