Back in the good old days, banks made money by lending at higher interest rates than they paid on deposits (such as savings accounts and CDs). Banks held loans instead of reselling them to investors via Wall Street, so they were careful about lending money. Otherwise, bum borrowers might stiff them and put the bank out of business. To grow revenue and profits, banks lent more money.

That was long before you and I funded the Troubled Asset Relief Program with our hard-earned tax payments.

Winning by losing less
Lately banks have been improving their profits by reducing their loan losses. Yep, you read that right. Instead of making more loans, banks are generating a big chunk of their profits from lowering the amount they expect to lose on existing loans. And a large portion of the improvement in bank earnings is due to losing less money on loans.

It is not a sustainable strategy.

Lower loan loss reserves were the primary driver of Wells Fargo's (NYSE: WFC) 48% year-over-year increase in first-quarter profit. Citigroup's (NYSE: C) first-quarter net loan loss reserves fell $2.1 billion year over year.  For perspective, Citi's net income for the quarter was $3.0 billion. Even at JPMorgan Chase (NYSE: JPM), widely considered the most solid big bank, a reduction of loan loss reserves accounted for nearly half of first-quarter earnings.

For the six largest U.S. lenders -- Bank of America (NYSE: BAC), JPMorgan, Citi, Wells Fargo, Goldman Sachs (NYSE: GS), and Morgan Stanley (NYSE: MS) -- profits before taxes and "provisions" (loan losses and one-time items) slid a whopping 40% year over year in the first quarter.  Here are some specifics:


Q1 2011 Change in Pre-Tax, Pre-Provision Income

B of A (55%)
Citi (48%)
JP Morgan (31%)
Wells Fargo (32%)

Source: Bloomberg News.

Revenue at the same six large lenders fell more than 13% year over year in the first quarter, driven by a decline in both lending and fees. That doesn't compare very well to the 302 S&P 500 index constituents that have reported the first quarter; as a group, these companies had revenue growth of more than 10%. Excluding financials, they increased profits 24% year over year.

Now what?
Dodd-Frank has hit banks in the fees, and I wouldn't bet on Congress backing off on that anytime soon. According to the Federal Deposit Insurance Corp., deposit-account fee income for the industry fell 21% year over year in the fourth quarter.  

With two large profit sources drying up, banks will need to turn elsewhere for revenue and earnings growth. It's no wonder banks are already loosening their lending standards in an attempt to boost new loan issuance.

Looking for loans in all the wrong places
Banks have been more willing to lend since early last year, according to a Federal Reserve survey of senior lending officers. But while loan demand has picked up modestly, it remains weak. What's more, there's a strong argument to be made that loan demand will remain weak for at least several years ... and perhaps longer.

Foolish takeaway
What's not to hate about bank stocks? Excluding "provisions" (one-time items and unsustainable loan losses), banks' pre-tax profits are tanking. Real estate continues to struggle. Dodd-Frank is hurting fee income. Consumers are strained by rising prices for gas and food and by shifting to living within their means (often forcibly, as credit gets taken away). Many companies need to reduce their debt, too.

What's a poor bank to do? For now, reductions in loan losses and loan loss reserves are big contributors to bank earnings and earnings growth. Eventually, however, that strategy runs its course. If banks can't find a new source of profits, bank earnings will start looking a lot more like the pre-provision earnings that slid 40% in the first quarter.

If you're not scared out of bank stocks, The Motley Fool recently introduced a free My Watchlist feature that can help you watch your back. You can get up-to-date news and analysis by clicking below to add companies to your watchlist now:

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.