Large banks took full advantage of improving credit quality during the third quarter, slashing provisions for loan losses and allowing more profits to fall to the bottom line.
That trend could continue in coming quarters as banks reduce reserves to account for a drop in nonperforming assets. This potential for falling credit costs in an improving economy - known as "credit leverage" - may play a strategic role in Bank of America Corp.'s proposed acquisition of FleetBoston Financial Corp.
In the third quarter the 15 largest publicly traded U.S. banks took an aggregate $4.6 billion of provisions for loan losses, 20% less than they did in the second quarter and less than half the $9.9 billion they took in the third quarter of last year, according to an American Banker analysis of bank financial statements. (State Street Corp., which has eliminated commercial lending as a core business, was omitted from the analysis.)
Improving credit quality - as well as accounting trends - explains the lowered provisions.
"Banks are still more than adequately reserved," said Anton Schutz, the portfolio manager for the Burnham Financial Services fund. "It's not the chargeoffs that matter; it's the nonperformers, and nonperformers are dropping pretty rapidly."
Aggregate nonperforming assets for the largest 15 banks fell 8% from the second quarter and 17% from a year earlier, to $31.2 billion. Reserves totaled 146% of nonperformers, continuing the rise from 137% at the end of the second quarter and 123% at the end of the third quarter last year.
Lower provisions are the result of excessive provisioning in earlier quarters, and the benefit to earnings could spill over into the next few quarters.
The median bank provision was 85% of net chargeoffs in the third quarter, after being equal to net chargeoffs in the second quarter and slightly in excess of net chargeoffs a year earlier.
Only two banks, BB&T Corp. and Fifth Third Bancorp, had provisions that exceeded chargeoffs last quarter. Wells Fargo & Co., U.S. Bancorp, SunTrust Banks Inc., and KeyCorp each provided about as much as they charged off. The remaining banks had provisions that were lower than chargeoffs. The provision at J.P. Morgan Chase & Co., for instance, was just 21% of net chargeoffs.
"In an environment where credit gets worse, people overprovision," Mr. Schutz said. "Too many guys went over. Fleet, J.P. Morgan, Bank of America, to name a few, clearly have the opportunity to leverage that, and I think there's still more opportunity."
In fact, a withdrawal from reserves could be a "potential surprise out of the Fleet/Bank of America deal," he said. "If credit quality continues to improve, they can certainly recapture some of those costs."
Analysts made note of that possibility after listening to the chief executives of Fleet and B of A discuss their transaction on Monday.
"That's one thing that Bank of America intimated when it announced the Fleet deal," said Brock Vandervliet, an analyst at Lehman Brothers. "They are getting these massive reserves that Fleet has set up," and over time they could release those reserves and boost profits.
Fleet, which struggled for much of last year with bad credits, had reserves of $3.1 billion, or 133.68% of nonperforming assets, up from 122.86% in the second quarter and 99.15% in the third quarter last year. Its provision for loan losses was down 7% from the second quarter and 86.8% from the third quarter of last year.
Mr. Vandervliet referred to Fleet's reserves as "kind of a hidden asset." If the two banks "don't get the cost takeouts or revenue enhancements that they think they will, they can just decide to take down that reserve a little bit more."
How banks handle reserves and provisions has been a matter of some debate.
The American Institute of Certified Public Accountants has been working on new rules that would overhaul the accounting for loan losses, and analysts say that effort has motivated bank accountants - even though the rule is not complete yet and is already under fire from banking regulators.
One tenet that the CPA group has stressed is having reserving policies that are "directionally consistent" with economic conditions; banks that perceive improving economic conditions should therefore provide less for loan losses.
But not all analysts are comfortable with the dropping provisions.
"You would think that they would wait a little longer, especially those who are the least well reserved in the first place," said Tanya Azarchs, a managing director at Standard & Poor's Corp. "It's been an interesting trend, because the banks that are the least well reserved are the ones that reversed more reserves than others."
Lower provisioning was more apparent at the large banks than at the small ones, because they have more sophisticated reserving methodologies, Ms. Azarchs said.
"When loan quality turns, they are going to respond more quickly," she said. "It is closer to kind of the pay-as-you-go mentality that the accountants are working toward. It may be the brave new world of what we're going to see."
J.P. Morgan Chase provided $223 million for loan losses in the third quarter, despite net chargeoffs of $1.1 billion. The low level of provisions was caused largely by a reversal of $181 million of credit costs within its investment banking unit, a sign of marked improvement in its commercial and industrial loan portfolio just a year after it made an outsized provision of $1.3 billion for that segment of its business.
Still, its coverage ratio improved to 129% from 125% at the end of the second quarter, as nonperformers dropped 32.7%, to $3.7 billion.
Large banks "have been unanimous in saying that their accountants are pressuring them," Ms. Azarchs said. "The accountants, being suspicious of the reserve as way of managing earnings, wanted the banks to sign on to a very strict methodology and to adhere to it consistently."
Regardless, that suspicion hasn't entirely eliminated the opportunity.
"The banks still have some latitude, without a doubt, to manage the [earnings] number using the provision," said Christopher Bingaman, the portfolio manager for the Diamond Hill Bank and Financial Fund. "There's been a lot of discussion about it, and different interests out there between the regulators and the accounting board. The accountants would rather see more purity and less latitude for the banks to use the provision and move things around, but the regulators still want to give the banks a lot of latitude, and the regulators still have a lot of influence."
But Mr. Bingaman saw widespread evidence of improving credit quality, too.
"It was a very clear trend," he said. "It has been for a couple of quarters now, but this quarter was really very clear. Almost every single large bank I can think of showed improvement."
Credit leverage will become more apparent as long as the economy holds up, Mr. Bingaman said. The logical candidates to seize that advantage are "the guys that were most adversely affected" by the earlier credit issues - "the guys with big C&I books."
