Small Cap Watch List (Track at Marketocracy) member First Regional Bancorp (FRGB) today reported strong net income for the second quarter ended June 30, 2007. Total assets, deposits and net loans all posted increases over the prior year, although net income for the first six months of 2007 was approximately 2.4% below last year’s record first half. Net income for the second quarter of 2007 was $8.6 million, equal to 66 cents per diluted share, compared with $9.6 million or 74 cents per diluted share in the corresponding quarter of 2006 and consensus estimates of $0.67.

Part of the shortfall in earnings was likely due to the company’s decision to take a higher loan loss reserve:

To keep pace with loan growth, First Regional added $300,000 to its loan loss reserve in the second quarter of 2007. This brought the balance of the reserve to $21.1 million at June 30, 2007, compared with nonperforming assets of just $13,000 as of the same date.

It may seem like a $21.1 million reserve against just $13,000 in nonperforming assets is overly conservative. But last year the company added $1.5 million to the reserve. If the company had simply taken the same amount as a reserve this year, net income would have been about 10% lower than reported. In terms of the total loan balance of $1.9 billion, the reserves are slightly more than 1%. We have seen from the Bear Stearns example how quickly loans can become worthless.

This is the second time I’ve noted that additions to the loan loss reserve were below the prior year levels.  It could be as simple an issue as higher actual losses last year and improved credit performance this year. However, given the overall lending environment I would expect the opposite. It is something I will continue to keep an eye on.