Originally posted by Yuval Bar-Or on Oct 12, 2012
It’s earnings season, and this time the focus is on reserve releases at banks. Reserves, as the name implies, are funds set aside to absorb expected losses. Reserve releases occur when banks feel that storm clouds have cleared and that there is no longer a need to maintain such a large buffer of reserves. In “releasing” reserves bank managers are able to redirect freed-up dollars to earnings. According to a Wall Street Journal analysis, “The four biggest U.S. banks have released $18.2 billion of reserves over the past four quarters reported, or 23% of their pretax income.” Among these are Bank of America Corp. (BAC) and Citigroup Inc. (C).
So, are reserve releases a bad thing?
On the face of it, the releasing of reserves (as an economy improves) is a reasonable action. It is typical to observe reserves building up as banks’ expected losses mount, and to see a reversal when the dust settles. But some caution is required.
Finance professionals (institutional investors and analysts) are well aware of the boost to earnings from reserve releases, and they adjust their analyses accordingly. Smaller, less sophisticated investors may not be aware that earnings have been boosted by reserve releases. They may incorrectly interpret the dramatically rising earnings as definitive signs that the economy has turned the corner, signaling clear skies ahead.
In fact, with concerns about Europe and China ongoing, as well as potential conflict in the Middle East, there are still significant clouds on the horizon.
Perhaps most importantly, recent reserve releases are a painful reminder that banks may still not be “getting it” when it comes to risk management best practices. Professional risk managers know that the key to managing risk is to be proactive. Instead of waiting for damage or loss to manifest and then trying to clean up the mess, it is far better to anticipate and take preventive measures in advance. The ongoing reserve releases are a painful reminder that banks took too long to set aside reserves to address significant housing market losses. Instead of being ahead of the curve, banks reacted after the fact. This is especially disturbing considering that reserves are set aside to cover expected losses, i.e., those that bankers are supposed to be able to predict. (In contrast, unexpected losses are addressed through economic capital).
While bankers reactively raised reserves several years ago, they are now proactively (and perhaps prematurely) releasing them.
If the risk management logic is so obviously against this behavior pattern, why do banks persist in exhibiting it?
A simple answer is that bank management teams are following incentives and catering to financial markets’ short term thinking. As a downturn looms, banks are reluctant to increase reserves because such actions lower earnings, potentially depressing stock prices and affecting management bonuses and promotions. When it becomes clear that reserves are urgently needed, the banks must make enormous reserve contributions to catch up. Many of them refer to this as “taking a hit,” and they prefer to take one big hit rather than steady reserve increases because the single big hit is soon forgotten by markets focused on 90-day (quarterly) reporting windows. When markets stabilize, banks waste no time in releasing reserves, seeking to (as soon as possible) improve their earnings picture and benefit from improved bonuses.
No One Wants to be First
Imagine one bank that decides to do the right thing. As storm clouds gather, the bank increases reserves significantly and proactively. Here’s where this sad story turns truly ironic. Instead of being given credit for responsible, forward-looking risk management, the market concludes that this bank has deeper problems than the rest, otherwise why would it be the only one increasing reserves? And so, the market hammers that bank’s stock price, while the less-responsible competitors are unaffected. Fear of such an outcome, in markets focused on quarterly earnings reports, constrains bank management teams from doing the right thing.
Whenever we see large reserves being released, which is inconsistent with proactive risk management and proper strategic planning, we are reminded that bad habits die hard in the banking industry.