Bank of America Faces Major Earnings Dip When Reserve Releases End

NEW YORK (TheStreet) -- Large-cap bank have seen a major boost from the release of loan-loss reserves over the past several years, and a return to typical provisioning for reserves could have quite a negative effect on earnings.

Banks typically set aside money for loan loss reserves each quarter based on their loan-loss expectations. For commercial loan portfolios, provisions are decided upon on a per-loan basis. Banks take a statistical approach for mortgage loans and other types of consumer loans. The trend -- it's human nature really -- is for banks to under-reserve during "good times" and over-reserve during and immediately after recessions.

This is in part because regulators don't want banks to use their reserve provisioning activity to smooth out earnings increases, and have traditionally frowned upon high levels of loan loss reserves when net charge-off rates are low. Investors also frown upon high levels of reserves, because they lower banks' returns on equity.

But this counterintuitive habit makes the bad times really bad, as we saw in 2008 and 2009 at the height of the real estate crisis, when banks really took it on the chin while adding to reserves.

During the fourth quarter of 2013, Bank of America's (BAC) provision for loan loss reserves -- the amount added to reserves, thus lowering pretax earnings -- was $336 million, while the company's net charge-offs -- loan losses less recoveries -- totaled $1.582 billion. So the company saw a $1.246 billion boost to pretax earnings from setting aside less for reserves than it charged-off for nonperforming loans. This is appropriate at this stage of the economic recovery, considering that the bank's annualized ratio of net charge-offs to average loans was 0.68% during the fourth quarter and its $17.428 billion in loan loss reserves covered 1.88% of total loans as of Dec. 31.

Bank of America has plenty of excess reserves right now. But the reserve releases can't go on forever, and at some point the bank is likely to return to making provisions for reserves at similar amounts to its loan losses.

With this in mind, KBW's analyst team put together two sets of numbers to estimate what effect "normal" provisioning levels would have on earnings for 11 large-cap U.S. banks. Based on fourth-quarter numbers, if the banks were to make provisions for loan loss reserves matching median levels for the past 23 years, Bank of America would see its earnings lowered by 37 cents a share, or 37% of its core fourth-quarter earnings of a dollar a share.

With the understanding that the above analysis could be overly aggressive, KBW put together another set of numbers showing the effect on earnings if the banks made provisions for loan losses that matched their fourth-quarter net charge-offs. In this case Bank of America's fourth-quarter core earnings-per-share would decline by 31%.

The big bank that would see the second-largest declines under the first scenario is JPMorgan Chase (JPM), with KBW estimating an earnings decline of $1.04 a share, or 19% of core fourth-quarter EPS of $5.60. Under the second scenario -- provisions for reserves matching fourth-quarter net charge-offs -- JPMorgan's earnings decline would be 91 cents a share, or 16% of core EPS.

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