What's the Deal With Bank Reserves?

Understanding a bank's loan loss reserve is tricky, but it will be an important topic as we head into first-quarter earnings. The Wall Street Journal reported that banks may need to boost their reserves, which could diminish earnings in 2007. Here's a quick refresher on reserves before earnings season gets under way.

Loan loss provisions
When a bank makes 1,000 loans during the quarter, it knows from experience that, say, 1% of those loans will go bad. It doesn't know which ones will go bad -- it just knows from statistical experience that 10 of those loans will not be repaid, or will become slow-paying loans.

Rather than waiting for the credit loss to occur, a bank uses its best judgment to account for those losses through the provision for loan losses, a non-cash charge to earnings. Here's a simplified income statement for Ohio-based KeyCorp (NYSE:KEY), highlighting the provision for loan losses.

Again, the $150 million loan loss provision is not a cash expense. Instead, that $150 million charge builds the loan loss reserve on the balance sheet. The reserve provides a cushion if and when customers don't repay their loans. Without this cushion, there's a chance the bank could be caught with little or no capital.

Think of the reserve as a bucket of water that should stay full. Water leaks out of the bucket when the bank abandons hope of collecting on a loan (called a charge-off). Every charge-off causes the reserve to shrink. If this reserve gets too low, the bank replenishes the reserve with the provision for loan losses. Over time, provisions for loan losses should be about equal to charge-offs, ensuring that the reserve doesn't get too low.

The bank can also recover previously charged-off loans, which adds to the reserve. On the way out of a recession, a bank can frequently lessen its loan loss provision on the income statement because recoveries of charged-off loans build up the loan loss reserve.

Putting it all together
The important things to remember are that the provision for loan losses builds the reserve, and charge-offs deplete the reserve. For example, KeyCorp's reserve fell in 2006, as net charge-offs outpaced the provision for loan losses:

What next?
Now that you understand reserves, the next step is to put the numbers into some context. Look at reserves as a percent of loans, as well as the trends of the loan portfolio. If the bank is making many high-risk loans, it must increase its reserves. You'll find some reserve data below to get you started.

So, what comes through the income statement depends on the loan loss reserve and on the company's estimates of what loan loss activity will be. If banks need to increase their reserves on the balance sheet, as the WSJ suggests, then we'll be seeing higher loan loss provision charges on the income statement.

Like any other company, the interplay between balance sheet and income statement is very important. These statements can't tell you everything you need to know about the conservativeness or riskiness of a management team, but they can give an investor a very good starting point for assessing a company's financial condition.

Further fiduciary Foolishness:

• Bank Investing 101
• M&T Bank's Rude Alt-Awakening

This information was once a part of the Drip Port. It has been updated by Fool financial services editor Joey Khattab, who does not own any of the shares mentioned. The Fool has a disclosure policy.