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Harvesting of Loss Reserves and the Art of Bank Earnings

January 18, 2012

Over the last 2 quarters (and for some banks for a somewhat longer period), the earnings of most banks has been procured by harvesting loan loss reserves.  Citigroup and JP Morgan are just the latest in a long series of banks that have seen decent earnings even as their core franchises slip away.  But for Citi reducing loan reserves by $1.5 billion last quarter, the earnings picture, already optically bleak, would have been starker.  But it is not just American banks that are playing this game.  Banks in Asia and Europe have been treading along this path for sometime now.  Obviously, this cannot be an endless source of earnings management.  At some point in the second half of this year, the old banking emperors will be found to be swimming naked.

Harvesting of bank reserves is bad not only because they present a false view of earnings.  On the back of the false earnings, senior management transfers value (through bonuses) to itself and other employees while leaving creditors and shareholders stranded.  No wonder banks are trading at steep discounts to their horrifyingly suspect book values. First the bank does not provision adequately for loan losses by pretending that suspect evergreened loans (remember Japanese banks?) are performing.  Then it releases reserves without the credit quality of borrowers improving (how can credit quality improve during the quarter in which the Baltic Dry Index halved?).  Both are recipes for impending disaster.  But bank CEOs will not be there to clean up the mess.  Creditors, sovereign wealth funds, pension funds and other long term investors will foot the bill.    Providers of long term capital should start doing a detailed analysis of the banks they are exposed to, paying particular attention to evaluating how much of the “deferred tax assets” on a balance sheet have to be written off and the impact that would have on a bank’s capital adequacy.

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From → Credit Analysis

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