Oct. 14 (Bloomberg) -- Delay-and-pray. For much of this year that was the strategy for banks when it came to the reserves they set aside to cover souring loans. Now, third- quarter earnings might show whether this gambit is paying off.

Most banks let reserves for loan losses dwindle as a percentage of non-performing assets, mostly past-due loans, on a bet that growth of dud loans would slow. They did this to sidestep the need to rebuild reserves, a move that hits profit.

The third quarter will prove an important test. If the growth of troubled loans has slowed, banks will get to breathe easier and hold off on diverting money to cover losses. That would bolster earnings at least through the end of the year.

If non-performing assets have continued to climb, as they did in the first two quarters, banks will have a tougher time arguing that reserves are sufficient. Many will have to start taking action, and cutting into profit, or risk setting the stage for a fourth-quarter bloodbath.

With the stakes so high, investors will need to watch that banks don’t try to game these figures. This is a danger because the treatment of non-performing assets can differ from bank to bank, FBR Capital Markets Corp. banking analyst Paul Miller said in a research note earlier this week.

These figures may even differ between a bank’s regulatory filings and what it shows investors in financial statements. Among the top 25 banks and thrifts, second-quarter non- performing assets reported in regulatory filings known as call reports were 17 percent higher than those reported to investors, Miller noted.

Gaining Leeway

How does that happen? Under regulatory filing rules, banks must wait six months before they stop carrying as a non- performing asset most loans they modify, Miller said. Under generally accepted accounting principles, non-performing assets aren’t defined. That gives banks more leeway in how they treat modified loans and when they stop including them in non- performing asset totals.

As mortgage modifications pick up pace, this may become more of a concern, since banks can help earnings if they tamp down non-performing asset figures.

“Banks have got themselves in a corner by talking up stabilization of the housing market, but when you go into the trenches nothing is stabilizing,” Miller said.

The reserves issue is somewhat less of a concern for big banks such as JPMorgan Chase & Co., which kicks off bank earnings season with its report today. It and Bank of America Corp.,Citigroup Inc. and Wells Fargo & Co., all have reserves that are equal to more than 100 percent of non-performing assets.

Feeling Pressure

That doesn’t mean they’re out of the woods. By adding to reserves at a slower pace this year than increases in non- performing assets, even these banks may feel pressure to be more aggressive in adding to their buffers for loan losses.

Bank of America’s reserves, for example, had declined to 116 percent of non-performing assets at the end of the second quarter. That is getting low for a bank of its size. By comparison, JPMorgan had a ratio of 170 percent.

Wells Fargo will face particular scrutiny, given that its reserves fell to 128 percent at the end of the second quarter from 181 percent three months earlier. Investors might get antsy if the bank again tries to bolster profit in this way.

The issue is more acute at smaller banks. They tend to keep reserve levels lower to start with, usually less than 100 percent. That’s because they have smaller credit-card and auto- loan portfolios, which typically produce more severe losses.

Mounting losses from the mortgage mess and credit crunch have now driven reserves at many smaller banks below 50 percent of non-performing assets. Their cushion to absorb losses is getting thin.

Housing Rescue

There is some optimism that an uptick in the housing market this summer will have taken some pressure off the growth of troubled mortgage assets. That may allow some smaller banks to hold off on shoveling loads of money into reserves.

Weighing against that are the growing odds of rising losses from commercial real estate and construction lending.

“For many of the regional banks, we expect large credit provisions to largely erase profits again this quarter,” analysts at CreditSights, Inc. said in a report this week.

And there is a question of how long regulators can allow some smaller banks to play the delay-and-pray game, given how low reserves have fallen. Of 545 publicly traded U.S. banks with more than $500 million in assets, one-fifth have reserves that are less than 35 percent of non-performing assets, according to Bloomberg data.

That doesn’t give them much room for maneuvering if the U.S. recovery is drawn out for several more quarters.

How banks balance profit against reserves this earnings season may determine whether investors wind up as the ones left praying.

(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)

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To contact the writer of this column: David Reilly at dreilly14@bloomberg.net

Last Updated: October 13, 2009 21:00 EDT