Published: August 17, 2010

New international banking regulations agreed to over the weekend call for banks to increase their cash reserves. This is the money that banks keep on hand to cover bad loans, which all banks have in good times and bad. The new rule stems from the subprime-fueled financial crisis, which caught many banks with too many bad loans and too little cash in the kick.

The new regulations call for banks to keep 7% of the balance of their total loans in reserve. So if a bank makes $100 million in loans, it needs to set side $7 million for the ones that go bad. Before the new rule, banks had to keep only 2% of total loans in reserve.

These reserves are cash, and cash comes from only one place -- earnings. So the question for investors today and going forward is whether the new reserve requirements are going to result in huge charges against earnings as banks seek to comply with the new rule.

To determine this, I used regulatory data for the second quarter -- the most recently reported -- and I compared each bank's loss reserves to its total loans. Frankly, it's not a pretty picture. Most banks don't have anywhere near 7% of their total loans in reserve. Not surprisingly, the national average is 1.9%, or just below the previous requirement and less than a third of what they need.

Here is how some of the nation's largest banks fared:

Bank of America (NYSE: BAC) has a loan portfolio of $713.7 billion and loan-loss reserves of $25.6 billion, or 3.6%. The bank needs to add some $24.4 billion to its cash reserves to meet the new regulations. BofA typically earns about $3.1 billion a quarter (net of normal loss-provision contributions), which means complying with the new rule could consume about two years' worth of earnings.

J.P. Morgan Chase (NYSE: JPM)'s loans total $538.1 billion, and it has fairly strong reserves of $22.5 billion, or 4.2% of its total. To meet the new rules, Chase needs to add $15.2 billion to its reserves. At its current level of earnings, Chase could build its reserves up to the required level in less than a year.

Wells Fargo (NYSE: WFC) has lent $703.2 billion. It has $21.0 billion in reserves, which is 3.0%, less than half what the new rules require. Wells needs to have $49.2 billion on hand, or $28.2 billion more than it has. If Wells can maintain earnings at $3.0 billion a quarter -- where it is today -- then the bank will need to devote all of its earnings for the next nine quarters to bolstering its reserves.
 

Citigroup (NYSE: C) is in the best shape of the major banks. It has a total of $580.7 billion in loans out, with $37.1 billion in reserve, which amounts to 6.3% of the total. Citi needs to only add $3.5 billion to its cash cushion to meet the new guidelines, which is about a quarter's worth of earnings.

Banks clearly have their work cut out for them, but they aren't exactly up against a clock: The nation's financial institutions have eight years -- 32 quarters -- to meet the new rules. That generous time frame and the fact that the rules didn't ask for even more money, which some had certainly proposed, is one reason Wall Street is cheering today, especially in the financial sector.

Banks are still working through a lot of bad loans, and more loans that usual are past due. But net interest margins are healthy, to say nothing of the $19.3 billion in fees banks charged in the last quarter alone. That means banks can and will slowly burn off the bad loans, leaving plenty of cash to bolster their reserves.

Action to Take --> If you've never considered Citigroup, now might be the time. The bank, one of the nation's largest, is strongly reserved and it's profitable. Because it won't have to put its earnings to work building its reserves to meet the new 7% rule, Citigroup will be free to use its cash to buy back the stock it sold Uncle Sam during the bailouts, which could signal the bank's return to its pre-financial crisis state of good health (with a few lessons learned -- I'd argue the bank has seen the folly of piling on more and more risk and has become somewhat more disciplined about managing costs). The stock is a steal under $4.

I ran this data on every bank in the country. So if you'd like to see how your bank measures up, email me at andy@streetauthority.com, give me the name of your bank and where it is based, and I'll email you my findings.

-- Andy Obermueller
Chief Investment Strategist
Government-Driven Investing, Fast-Track Millionaire