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Banks Are Strong Financially. Why Earnings Don’t Reflect It.

Wells Fargo added $8.4 billion to reserves in the second quarter of 2020, released $1.6 billion a year later, and added $580 million in the most recent quarter.

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In an already confusing year for banks, second quarter earnings were even more of a head scratcher and it may have to do with earnings estimates.

Put simply, the banks are in good financial health but their profits were weaker than they were last year—and in many cases, they were far weaker than analyst estimates.

When one bank misses, it is a question about the bank’s performance. When several banks miss, it is time to question the estimates. For investors, the key is realizing that a decline in earnings doesn’t have to be catastrophic. 

Profits were already expected to be down this year as the nation’s biggest banks have to contend with a huge drop in capital markets activity and early signs of a weakening economy.

But what may not have been fully factored into this quarter’s earnings estimates was the fact that last year’s earnings were inflated as banks released billions of dollars they had earmarked for soured loans—not to mention capital markets activity was also absurdly high.

When loan losses didn’t materialize, those reserves were released back into earnings. Now with banks preparing for an economic slowdown, they’re building up their reserves again but nowhere near the levels they did in 2020.

Just take a look at some of the largest banks.

In the second quarter of 2020, JPMorgan Chase boosted its reserves by $8.9 billion, in the second quarter of 2021 it released $3 billion, and then in this most recent quarter it added $400 million.

Wells Fargo (WFC) had a similar story over the last two years: it added $8.4 billion to reserves in the second quarter of 2020, released $1.6 billion a year later, and then added $580 million in the most recent quarter.

These gyrations in reserve builds and releases are the result of a recent accounting standard—dubbed Current Expected Credit Losses, or CECL—that went into place at the start of 2020. The idea was that it would force banks to prepare for bad times when the economy was doing well so that they would be better positioned when things turn south. The reserve builds are for losses that may or may not occur and have injected new volatility into bank earnings.

Unfortunately, in the methodology’s first year in practice, the economy experienced an unprecedented pandemic-induced shock. Barron’s previously wrote how banks would actually be poised to outperform despite massive reserve builds two years ago.

Now, in a somewhat more normalized economic cycle, Wall Street may be unsure of how to project the ebb and flow of reserve builds and releases. A bank may add to more reserves to be extra prudent even though its underwriting is sound.

With this quirky accounting, it is no wonder that several banks including JPMorgan Chase, Morgan Stanley , and Wells Fargo missed estimates this past week and why bank executives get frustrated talking about reserves.

“The company has got huge underlying earnings power and consistent revenues in [the commercial and consumer bank], asset management, custody and payment services,” Jamie Dimon, chief executive at JPMorgan, said on a call with analysts. “And then we have some kind of fairly volatile streams. Now we’ve got the CECL, which obviously can go up or down quite a bit. But again, that’s an accounting entry.”

In Friday’s trading, markets seemed to get the picture that banks were healthy despite earnings misses as financial stocks were one of the better-performing sectors in the S&P 500. 

But for banks and their investors, this newer standard faces a steep—and expensive—learning curve. 

Write to Carleton English at [email protected]

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