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Credit Improvements Still Boosting Bank Profits (Update 1)

Updated from 11:17 a.m. ET with afternoon market action and comment from FBR analyst Paul Miller.

NEW YORK (TheStreet) -- Second-quarter earnings season has been strong for most the nation's biggest banks, but it's always good to look beyond the headline numbers, which are still seeing a boost from the release of loan loss reserves.

Banks follow a counterintuitive practice when it comes to setting aside reserves to cover loan losses. The quarterly addition to loan loss reserves is called the provision for loan losses.

Since the provision directly affects pretax earnings, banks can manipulate their quarterly results by making outsized provisions for loan losses, or by allowing their loan loss reserves to decline. So during times of strong credit quality, banks need to be careful not to "over-reserve," because this might be seen as an attempt to smooth out earnings increases over extended periods.

So reserves are relatively low during good economic times, and must be quickly boosted during a severe recession, just when banks may be feeling the revenue squeeze in all business lines.

All of the nation's large banks that reported second-quarter results through Friday released loan loss reserves during the second quarter, with the exception of State Street (STT), which doesn't count lending as a key business activity.

Wells Fargo (WFC) reported record second-quarter earnings of $5.5 billion, or 98 cents a share, increasing from $5.2 billion, or 92 cents a share, in the first quarter, increasing from $4.6 billion for 82 cents a share, a year earlier. The earnings improvement was driven by strong growth in investment banking, wealth management and retail brokerage.

According to data supplied by Thomson Reuters Bank Insight, Wells Fargo released $567 million in loan loss reserves during the second quarter. That compares to releases of $349 million in the first quarter and $532 million in the second quarter of 2012. So for Wells Fargo, the reserve release didn't drive the year-over-year earnings beat. It did, however, help feed the sequential earnings increase.

To better compare operating results from quarter to quarter, investors can use a quick back-of-the envelope calculation of pre-provision net revenue. Pre-provision net revenue is a bank's tax-adjusted net interest income, plus its noninterest income, less noninterest expenses.

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