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First quarter banking profits were going to be pretty tough without the coronavirus pandemic.
By implementing a new accounting rule on Jan. 1 that required them to estimate and record loan losses before they occur, the country’s four largest banks added $ 10.4 billion to their reserves. Then came spikes in unemployment and the shutdown of much of the economy, raising doubts as to whether customers could follow their credit card and mortgages.
By the time the banks released their report last week, they had accumulated an additional $ 17.9 billion in loan loss reserves on top of the initial adjustments for the current expected credit loss standard (CECL) – a figure that has served primarily to raise questions from analysts as to whether even that a mind-boggling total was enough.
“The only thing we can say for sure is that the first quarter loss estimates are going to be wrong,” said Michael Shepherd, director of Fitch Ratings Inc ..
The economic forecast underwent huge changes just between March 31, when the banks closed their books, and the start of the earnings season in mid-April, said Ross Eaton, partner at Oliver Wyman.
“If you think about how the economic forecast has turned, as late as early March we were talking about a slowdown. Then it was a slight recession. Then it was a deeper recession, ”Eaton said. “Now you have numbers floating around like annualized GDP growth of minus 35%.”
Congress had offered banks an extension to comply with the coronavirus relief plan accounting rule that President Donald Trump promulgated on March 27. But the details of the delay and the regulators’ interpretations made it unpleasant for most banks. JPMorgan Chase & Co., Citigroup Inc., Bank of America Corp. and Wells Fargo & Co. all implemented it on time.
Underlying economy
An accounting change, even as big as CECL, does not change the underlying economics of a loan. Bad credit will cause a bank to lose money under the new accounting as much as it did under the old accounting rules.
The difference is when a bank recognizes losses. CECL shifts the schedule until the day the bank grants a loan, even before a customer makes a late payment. The mechanics of bookkeeping mean that when a bank consolidates its loss reserves, it cuts its profits.
Developed in the aftermath of the 2008 financial crisis, when bank balance sheets looked healthy despite the collapsing markets, the idea behind CECL is to highlight potential credit losses and prepare banks for them before it not be too late. The Financial Accounting Standards Board published the rule in 2016 and large publicly traded companies were expected to comply by January 1. Credit unions, private banks, and small banks and public enterprises have until 2023 to follow it.
“The negative effect spills over into financial data much faster,” said Saul Martinez, Managing Director of UBS. “And that’s a more difficult thing to assess and estimate on a quarterly basis.”
The standard applies to all businesses, but banks and companies with large funding arms are the most affected. The rule requires companies to look to a “reasonable and sustainable” future, take into account past experience and assess existing conditions to make their best estimates of credit losses and set aside the corresponding reserves.
“We haven’t seen the stress emerge yet,” Jennifer Piepszak, CFO of JPMorgan Chase & Co., said on the bank’s April 14 call.
There is no standard formula or method for a business to estimate and record losses. The FASB intentionally created the standard to be flexible, within reason. But that means each bank makes different estimates based on its customer base, loans, and business makeup, as well as its vision for the future.
“All banks will use different assumptions to determine what their provision spending will be, so you can’t compare JPMorgan’s provision to Bank of America’s and take it like apples for apples,” Fitch’s Shepherd said. “It’s a challenge for us analysts.
Behind the numbers
Of the more than $ 28 billion in total anticipated losses forecast by JPMorgan Chase, Citigroup, Bank of America and Wells Fargo, JPMorgan has increased its reserves by $ 6.8 billion, the bulk of the group, and Wells Fargo has increased its reserves by approximately $ 3.1 billion. , the least of the four mega-banks. If a bank has a lot of credit card customers, like JPMorgan, he expects more losses than one with a large portfolio of commercial loans that are used to paying on time.
The macroeconomic forecasts used by banks also play a central role. The models each one uses could differ significantly, especially in how they forecast changes in the workforce and GDP.
“How can I disentangle the differences between Wells, Citi and JPMorgan? Martinez asked. “It’s difficult because the disclosures are inconsistent.”
To understand the accumulation of reserves, analysts have questioned bank executives about their calculations.
“What we would like to understand is what the main drivers are,” said Betsy Graseck, Managing Director of Morgan Stanley. “What are your prospects for GDP and unemployment over the reasonable and bearable period and the remainder of the loan term?” “
In addition to the disaster and gloom of a spiraling economy, banks must also consider the potential bright spots ahead. One of them is the payment of the stimulus check integrated into the emergency plan. Many Americans received money the same week as banking income kicked off.
“Are they going to use any of the stimulus measures to keep abreast of their debt?” Said Graseck. “This borrowing behavior, I think, is one of the hardest things for anyone to model.”
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