Do the banks’ words match their actions on loan loss reserves?
One of the main reasons the banking industry struggled more than others during the coronavirus pandemic is that investors and analysts have struggled to understand the underlying risk of bank portfolios. The eerie nature of the coronavirus pandemic, along with the many government interventions and uncertainty ahead, has masked true credit quality. The loan losses did not materialize as they normally would during a recession, but banks have significantly increased their reserves, anticipating that the losses will eventually pile up.
Many bank management teams in the third quarter have taken action and made statements that suggest they are feeling better about their portfolios and the economy, even as the country heads into what many expect in a winter. hard. Can banks really feel better about credit quality with the upsurge in coronavirus cases?
Do the numbers and feelings add up?
Banks have significantly increased their reserves to prepare for potential future loan losses, but now many management teams don’t expect these losses to emerge until the second half of 2021. This makes some sense because banks don’t see many new defaults, and they typically won’t charge most loans, or consider debt bad, for 180 days. At the same time, comparing the total reserves of some banks to management’s projections of loan losses, it can be difficult to understand how the two support each other.
For example, Fifth Third Bank (NASDAQ: FITB), an approximately $ 180 billion Cincinnati-based asset bank, has set aside enough reserves to cover loan losses equivalent to 2.49% of its total loans. Still, Fifth Third CEO Greg Carmichael said on the company’s recent earnings conference call: “Looking at 2021, we continue to expect net charges for the full year to be. well below 1%. ” This means the bank has more than double the reserves it thinks it will ultimately need. If he really feels so confident about the expected charges, why does he need all those reserves?
Then take another regional bank, like assets of $ 60 billion People’s United Financial (NASDAQ: PBCT), which has built up enough reserves to cover losses on 0.94% of total loans. It seems to be towards the bottom of the reserve when you look at comparable banks, especially since People’s United has over 75% of its loan portfolio in the commercial sector. But management has expressed confidence in their reservation methodology, so I guess you could say the numbers and sentiment line up here. Yet despite the disconnect, I still feel better about booking Fifth Third because I’d rather have a bank that feels really good with credit but is still overbooked right now, given all the uncertainty. .
Several banks, including Fifth Third, also redistributed their reserves into their profits during the third quarter, suggesting that economic conditions may be better than they thought, an idea that has made some analysts skeptical. “Are you sure you want to set the tone at this point in the negative provision-taking cycle? I mean, you might be right, but you might be wrong, but we don’t really know how it’s going. unfold, “analyst Mike Mayo said on Fifth Third’s third quarter earnings conference call.
In all fairness, it is extremely difficult for anyone to be sure at this time. For the first time, banks are using a new accounting system called the Current Expected Credit Loss Methodology (CECL), which allows them to project losses over the life of loans as they enter the balance sheet. This essentially feeds the reserves. At the same time, Federal Reserve actions and government intervention have really lengthened the timeline of loan losses, so banks now have reserves on their books that they may not need. to use for months – maybe even over a year. Much can change during this time.
What to do with it
I can understand banks feel better about economic conditions. Another round of stimulus will likely come at some point, even if it’s after the election. And the personal savings rate is much higher, as are deposits throughout the banking system, suggesting consumers and businesses are bracing for uncertainty.
Where I caution is about listening to projections that are too far into the future, given how quickly things have changed. While many banking management teams seem to think conservatively and ignore a second wave of recovery in their modeling, I’m not sure if the banks have prepared for an absolute worst-case scenario, like, say, if there’s another round of shelter-in-place orders, or much more subdued economic activity in general. In the second quarter of this year, GDP fell by more than 30% and banks built up their reserves heavily. It might not happen again, but at this point it’s hard to rule out anything for sure.
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