Provisioning from U.S. banks slowed significantly in the third quarter, but reserve levels remained elevated as the industry braced for the potential of further economic turmoil.
Banks bulked up their reserving for credit losses when the COVID-19 pandemic first hit, racking up more than $100 billion in loan loss provisions during the first two quarters of the year. In the third quarter, provisioning returned to pre-pandemic levels as banks set aside $14.25 billion, down 77% from the second quarter. The drop helped ease what had been one major headwind to bank earnings.
Bankers hope the hefty reserve cushion they built during the first half of 2020 can absorb any loan losses that may unfold due to the pandemic. But the spread of the virus in the U.S. could complicate that outlook, given that another drop-off in economic activity could result in more widespread business failures and loan deterioration.
For now, most banks are holding onto their reserves rather than releasing them. "It's a lot easier to be conservative at this point and hold reserves … as opposed to be too quick to let reserves go and then see a reversal of the improvement in the economy and have to build reserves again," William Losch III, CFO at First Horizon Corp., told analysts on the bank's earnings call. The bank continued to add onto its reserves with $230 million in provisions during the quarter.
HomeStreet Inc. Executive Chairman, President and CEO Mark Mason, meanwhile, told analysts his bank will opt for an "abundance of caution" until the murky outlook becomes clearer. "It's all very uncertain at this point, and that's why we hold those reserves against that uncertainty."
Bank reserves stood at $244.27 billion at quarter's end, nearly double from a year ago and sitting around the levels following the 2007-09 financial crisis. The industry's accounting methods for booking reserves have shifted substantially since then, with larger banks adopting the new Current Expected Credit Losses accounting standard that prompts them to book reserves on all loans upfront rather than when individual loans begin showing signs of stress.
Smaller banks that did not adopt the CECL standard yet continued to raise their provisions during the third quarter. Diane Ellis, who leads the Federal Deposit Insurance Corp.'s Division of Insurance and Research, told reporters Dec. 1 that trend is not surprising and that future provisioning figures may be volatile as the outlook shifts every quarter.
Jennifer Demba, a regional and community bank analyst at Truist Securities, says the potential for an improved economic outlook as a COVID-19 vaccine becomes available makes it more likely that reserve levels could dip at the end of 2021.
"The progress of vaccine developments gives us more confidence that [loan loss reserve] levels have peaked and risk is skewed towards more stable or lower dollar loan loss reserves in 2021 and 2022," providing a boost to banks' earnings, she said in a Dec. 4 report.
Still, banks face challenges in determining their reserves under CECL because of looming economic uncertainties, such as whether Congress will agree on another fiscal stimulus package. As a starting point in their models, many banks use the Moody's baseline economic forecast, which assumed Congress would approve another round of fiscal help for individuals and small businesses.
But a lack of progress on fiscal talks made the baseline economic outlook seem a bit optimistic to many banks. In October, Valley National Bancorp executives said they shifted their CECL model to weigh Moody's adverse and prolonged recession scenarios a bit more heavily, a move that ultimately led to higher provisioning.
Jay Sidhu, chairman and CEO of Customers Bancorp Inc., said his bank is also taking a more conservative approach and reserving at levels "greater than what Moody's models would show." The bank took advantage of the "qualitative" adjustments to reserves that banks can apply to parts of their loan book they think could come under more stress.
"We could have justified having no reserve this quarter, but we chose to be more conservative," Sidhu said during an October investor call.
The qualitative overlays to CECL models are an "art, not a science," with each bank making different assumptions that ultimately make it hard for analysts to make precise comparisons, said Michael McTamney, vice president at DBRS Morningstar.
Even with the rise in reserves, actual credit losses remain muted largely because of the fiscal stimulus that Congress approved this year and other relief measures to help troubled borrowers. Credit losses should eventually tick up, but the "timing is so hard to predict," McTamney added.
"This is going to take a long time to play out," he said.
