Regulators' Wrangling Puts Bank Earnings Under Extra Scrutiny - TheStreet

Regulators' Wrangling Puts Bank Earnings Under Extra Scrutiny

Some observers wonder if changes in reserve and capital rules aren't allowing banks a back-door earnings boost.
Author:
Publish date:

Investors of bank stocks need to be watching Washington like hawks.

After a recent burst of activity, several of the nation's regulators are enforcing new bank accounting guidelines that, according to observers, may already be affecting banks' profits. And regulators are preparing more rules that could have an impact on earnings.

For investors, weighing the effect of new regulations is now complicated by long-running tension between a group of bank regulators and the

Securities and Exchange Commission

, the main watchdog for the securities market. Some obeservers believe a side effect of this tension is that banks are artificially boosting profits by exploiting an SEC push to clamp down on bank-earnings manipulation.

The Grasshopper

Fourth-quarter results suggest the SEC is steadily winning its tussle with four Washington, D.C.-based bank watchdogs that came to a head in the summer of 1999. In its role as overseer of accounting rules for public companies, the SEC wants to keep companies from socking aside money that they can draw on later to artificially boost earnings. Banks could be guilty of this if they put too much cash aside to cover defaulted loans. In 1998, the body required that

SunTrust

(STI) - Get Report

restate its earnings because it was allegedly over-reserving.

However, national bank regulators like the

Federal Reserve

, the

Office of the Comptroller of the Currency

, the

Office of Thrift Supervision

and the

Federal Deposit Insurance Corporation

want the institutions they watch to have solid loan-loss reserves to protect themselves against a rise in bad loans.

In a bid to present a common front, the SEC and the four bank regulators in July issued a joint letter agreeing on guidelines for setting loan-loss reserves.

Despite the compromise, the SEC seems to be quietly getting its way. The median loan-loss reserve at the nation's 25 largest banks was equivalent to 1.41% of loans in the fourth quarter. That's well below the 1.53% registered in 1999's first quarter, and shows banks are reserving less. "The SEC hasn't given up on this initiative in any way," says Hal Schroeder, a banks analyst at

Schroders

. The declining loan-loss reserve "is a supporting piece of evidence" that the SEC is still on the warpath on this issue, he adds. Schroeder last year criticized the SEC's reserve policy before the House of Representative's

Committee on Banking and Financial Services

.

The SEC declined to comment.

The Ant

The problem for investors is deciding whether some banks are using the SEC's initiative as a handy excuse to meet earnings expectations by skimping on reserves.

If a bank feels it's going to fall short of its quarterly earnings estimate, it could provision less to make sure it doesn't miss. Sean Ryan, analyst with White Plains, N.Y.-based

Byrne Ryan

, believes

First Union

(FTU)

may have done this recently (Ryan's firm does no investment banking and he hasn't issued a rating on First Union).

In the third quarter, the bank charged off bad loans of $175 million, and placed a $175 million provision into its reserve to cover the damage. "That's inadequate," says Ryan, who believes the provision should not only cover losses, but also reflect growth in the loan portfolio, so that the level of reserve is at least maintained. First Union's reserve dropped to 1.34% of loans in the third quarter from the previous quarter's 1.38%, which was already below the median level of its peers.

"We have an appropriate level of reserves," responds Tom Wurtz, First Union's Treasurer. "In the years 1998 and 1999 we fully covered or exceeded charge-offs with provisions."

And First Union, it should be noted, is by no means the only bank where the reserve ratio has dropped, as the table below shows.

The Aardvark

Now, it seems the bank regulators are trying to neutralize the effect the SEC appears to be having on banks' reserves. The regulators have little say on reserve accounting, but they call the shots over banks' capital levels. And this they're exploiting. In December, the four regulators

issued a statement that said they would toughen up capital, valuation and disclosure rules applying to securitization assets that banks retain on their balance sheets. Securitization is the practice of packaging up loans and selling them off. They added that loans to subprime, or higher-risk, borrowers would be treated more stringently in capital calculations.

Fourth-quarter numbers show that banks could be listening to the regulators on retained securitizations, says Charles Peabody, analyst at N.Y.-based

Mitchell Securities

. First Union,

KeyCorp

(KEY) - Get Report

and

Bank One

(ONE) - Get Report

all wrote down the value of retained securitizations, he points out. "I truly believe that these actions were taken in anticipation of where the regulators are headed in their oversight of the subprime/asset securitization business," he wrote in a recent report. Writedowns have to be deducted from earnings. (Peabody rates Bank One a hold, and First Union and KeyCorp a buy. Mitchell has done underwriting for none of them.)

And the regulators are stepping up their campaign.

The Wall Street Journal

last week reported that the FDIC is also drafting tougher capital rules for subprime lending. Dave Ellison, manager of the

(FBRFX)

FBR Financial Services fund, says "there's clearly a link" between the FDIC's move and the SEC's drive against overly high loan loss reserves. Not able to affect loan-loss reserves, "the bank regulators making banks aware of their concerns about credit quality from another angle."

Don't take your eyes off the capital just yet.