Shrinking Reserve Releases May Impact U.S. Bank Profits

Large US banks' financial results for the first quarter indicate a slowdown in asset quality improvement as loan quality measures near a cyclical trough, according to Fitch Ratings. This trend may pressure earnings if loan loss provisioning outstrips top line revenue growth.

As provision expenses increased notably for some banks in 1Q14, reserve releases fell to $2.5bn among the 12 large US commercial banks from $4.3bn last quarter. We expect reserve releases to continue to decline and likely reverse in 2014 as there is little room for further improvement in asset quality. The Office of the Comptroller of the Currency has also heightened regulatory scrutiny on the level of loan loss reserves and the magnitude of releases.

Nonaccrual balances continue to moderate for the large banks, but at a slowing pace, while net charge-offs (NCOs) are likely nearing the bottom of their cyclical range. Industry NCOs for virtually all asset classes were lower in 4Q13 than the prior 20 year average, with the notable exception of still elevated credit losses for home equity lines. While the averages are distorted by the huge losses during the financial crisis, Fitch expects some reversion to the mean in some areas, especially among auto loans and credit cards, where loss rates are likely unsustainably low.

Lenders are gradually lowering origination standards to stimulate loan growth, particularly in commercial and industrial, commercial real estate, credit cards, and auto loans. As a result, asset quality may deteriorate as these lower quality loans season, especially in a higher interest rate environment that could pressure the more marginal borrower. The most recent Fed's senior loan officer opinion survey from January generally indicated that banks eased their lending policy for C&I and CRE loans because of strong demand. A modest fraction of banks also reported eased credit card limits and loan rate spreads on auto loans.

Some loan growth in these asset classes will likely lead to a building of reserves over time, though loan growth remains lackluster. Total period-end loans for the large commercial banks as a group were essentially flat from year-end 2013, despite pockets of growth and a pickup in utilization rates as continued deleveraging in many consumer asset classes weighed down total balances.

A waning of reserve releases over time may pressure earnings for banks where results benefitted particularly from lower provision expenses. Reserve releases totalled 9% of pre-tax earnings on average for these banks (excluding BAC which reported a loss for the quarter). This is down from a 12% average last quarter. Assuming provision expenses rise with more robust economic growth, the individual impact maybe more muted. However, if provisioning increases without commensurate rise in top line revenue growth, bank profitability may be pressured.

For a complete rundown on first-quarter operating trends for US banks, including the CCAR stress testing results, see the special report "US Banking Quarterly Comment: 1Q13," published today at www.fitchratings.com.

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