Banks this year are operating under a new accounting methodology called the current expected credit losses (CECL) method, which requires banks to try and project losses over the life of a loan as soon as it is originated and put on the balance sheet. What this means, at least in theory, is that banks should be essentially front-loading their credit provisions initially to account for all potential losses on current loans. Thus, reserve levels should start to level off in subsequent quarters, building new reserves mostly for new loans. Following this thought process, again in theory, banks should have taken their largest quarterly provision in March.
But, obviously, with so much uncertainty because of the coronavirus and the first quarter of the year being the first time banks used CECL, I don’t think too many analysts were surprised to see second-quarter provisions at similar levels of those in the first quarter, or even a good deal higher. However, some banks saw their second-quarter provisions not just go up but more than double from first-quarter levels. Even though CECL is new and the coronavirus pandemic is an unprecedented situation, these increases in my opinion are concerning, because they essentially mean banks took too rosy of an outlook instead of thinking conservatively, especially in a fluid situation like this. Here are four banks that clearly did not do a great job of forecasting the economy at the end of the first quarter.
1. Wells Fargo
Wells Fargo (NYSE: WFC) took a roughly $3.8 billion provision in Q1, only to take a roughly $9.6 billion provision in Q2, a 153% increase from the first quarter. What was interesting in the first quarter is that Wells Fargo reduced the amount of total reserves it was setting aside for losses on commercial real estate and commercial construction loans. The first quarter ended on March 31. Many states had already implemented shelter-in-place orders at that point, and I feel like it was pretty clear that most retail, restaurants, and hotels were going to struggle in Q2, so this just seems like an odd move. Management teams can always manipulate earnings, so Wells Fargo may have purposefully underprovisioned in Q1, not wanting to take a loss so suddenly and feeling like it would be better to give the bad news in July, when investors would be more prepared.
2. PNC Bank
The $445 billion asset PNC Financial Services Group‘s (NYSE: PNC) earnings were propped up by the recent sale of its 22.4% ownership stake in the asset management firm BlackRock. So you may not have noticed it, but the bank also missed the mark on projecting loan losses in the first quarter. PNC took a quarterly credit provision of $914 million in Q1 and then roughly $2.5 billion in Q2 for an increase of roughly 169%, actually larger than Wells Fargo’s. The bulk of the provision in Q2, $1.7 billion, was set aside for the commercial portfolio.
Part of the way banks model for loan losses is by using underlying economic assumptions such as gross domestic product (GDP) and unemployment. PNC’s CFO, Robert Reilly, said on the company’s first-quarter earnings call that the bank assumed annualized GDP would contract 11.2% in Q2, but we now know that GDP contracted by nearly 33% in the second quarter. And it’s not like economists and research analysts weren’t saying these estimates in March, so it’s hard to see where this projection came from. I still think PNC is in a position of strength, given all the capital the company has built up. The bank’s total reserves for potential loan losses now amount to 2.55% of total loans, but management certainly used assumptions in Q1 that were too optimistic.
3. People’s United
The $61.5 billion asset People’s United Financial (NASDAQ: PBCT), which is largely based in the Northeast, took a $33.5 million provision in Q1 followed by an $80.8 million provision in Q2, representing a more than 140% increase over the linked quarter. The largest increase in reserves that People’s United saw was in its equipment financing portfolio, which is a type of commercial loan. Total reserves for that niche segment are now at about 2% of the total portfolio, which is up from less than 1% at the end of the first quarter. People’s United CEO John Barnes said the company was forced to increase reserves because most of the equipment finance loans have short durations. He said he still feels really good about the credit quality of this portfolio. At the same time, equipment financing loan volume is down $132 million from Q1. I know CECL is new and economic conditions are changing every day because of the coronavirus, but this just seems like a huge miscalculation. Additionally, CFO David Rosato said on the company’s first-quarter earnings call that the bank expected GDP to decline anywhere from 12% to 16%. Similar to PNC’s outlook in April, that was way off from reality. The bank is not performing too poorly from a profitability standpoint, but it’s important that management has a good handle on credit.
4. Regions Bank
The $144 billion asset Regions Financial Corp. (NYSE: RF), which is headquartered in Alabama, took a $373 million provision in the first quarter of the year. It followed that up with an $882 million provision in the second quarter, a 136% increase. The bank heavily increased the total reserves being set aside in its commercial loan book, and its investor real estate book as well. The bank does seem to be thinking conservatively now, having set aside total reserves amounting to 2.68% of the entire loan book. In the first quarter, while it’s a little hard to tell based on the wording, it appears that CFO David Turner says the bank expected GDP to drop 20% in the second quarter, which is better than some of the other banks mentioned above, but again still far away from reality.
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