Q4'20 reports could confirm upbeat credit outlook with high optimism on US banks

Sentiment on banks has rebounded dramatically, with the S&P United States BMI Banks Index starting the year up 65% from a March 2020 nadir, and many analysts saying the shares have more room to run.

The basic contours of the recovery story are clear. Despite a recession marked by the sharpest plunge in employment in at least 70 years, massive amounts of fiscal and monetary support look like they could hold credit losses to relatively modest levels. The pandemic is keeping big pieces of the economy offline, but the prospect for substantial additional federal help under a Democratic Senate could extend the bridge for idled workers and businesses through a protracted vaccine rollout. Interest rates remain low and lending has been anemic, but the yield curve has steepened.

Still, modest shifts in the potential timing of the narrative retain the power to surprise, as with the rally in bank shares spurred by the Federal Reserve's earlier-than expected decision in December 2020 to allow large institutions to resume stock buybacks. Investors will be watching fourth-quarter earnings reports for credit loss reserve releases that could cement recent optimism or warning signs that could raise doubts.

Analysts at Moody's expect releases are coming after banks amassed large loss cushions in the first and second quarters of 2020 and generally kept them about steady in the third quarter. But exactly when remains uncertain.

With the economy having improved since life-of-loan loss allowances were set under current expected credit loss accounting in the depths of the recession, "most banks would have taken reserve releases [in the third quarter] but for management overlays," Peter Nerby, a senior vice president at Moody's, said in an interview. "Another quarter under their belts, and I think it's going to be harder to use those management overlays to retain reserves."

Nevertheless, with the pandemic worsening through the winter and triggering renewed restrictions on in-person activities, "some managements may decide to have a more negative forecast that would allow them to ... maintain reserves," Nerby said.

Banks gave mixed signals in business updates late in the fourth quarter. In December, Citigroup Inc. CFO Mark Mason said reserve releases were more likely than builds, but JPMorgan Chase & Co. CEO Jamie Dimon said: "We're still about to go into the [COVID-19] winter. ... Most banks don't want to be in a position where they swing those reserves up and down every quarter."

JPMorgan's credit allowance did fall in the third quarter, but it said the decline was driven in part by runoff in home loans, and its allowance as a percentage of loans was about flat with the second quarter. Bank of America Corp. added to its reserves for commercial loans in pandemic-impacted industries in the third quarter but released reserves for consumer loans.

Mean analyst estimates have penciled in sequential increases in credit provisions in the fourth quarter for a number of public banks with more than $100 billion of assets and sequential drops in EPS for half of them. However, some analysts believe the consensus has yet to catch up with the more benign outlook.

B. Riley FBR analyst Steve Moss believes that EPS forecasts for 2021 should generally be 20% to 45% higher because expectations for credit provision expenses are excessive. "Economic improvement and strong loan loss reserves combined with limited [nonperforming loan] formation should result in sharply lower credit costs," he said in a note on Jan. 7. He added that credit provisions "close to zero" are possible for banks with low loan growth and that adopted CECL.

Mean estimates also anticipate sequential fourth-quarter increases in ratios of net charge-offs to average loans across the big banks, but not to levels that rule out reserve releases. "You're going to see rising nonperformers, rising charge-offs, and yet you could still see reserve releases because it's very much a forward-looking view [under CECL]," Moody's Senior Vice President David Fanger said.

The rebound in bank stocks has also tracked interest rates that have lifted off historic lows, with yields on 10-year Treasurys punching above 1% in January for the first time since March 2020. With economic activity still hemmed in by the pandemic, loans have continued to contract. But the steeper curve should help support bank revenues, and many analysts expect the interest rate environment to continue to improve for banks.

For banks with significant capital markets operations, analysts also anticipate continued strength in trading and investment banking, based in part on recent guidance from executives. Dimon said JPMorgan's trading and investment banking revenues were up about 20% year over year through roughly the first two months of the fourth quarter.

"It really is a function of volumes and volatility," Nerby said. Capital markets revenue should normalize over time, he added, but "it wouldn't surprise me" if robust performance carries over into the first quarter, especially with an increase in volatility driven by recent events in the news.

Despite the favorable themes for banks, the industry does remain exposed to serious setbacks.

"A nasty scenario for bondholders is a big reserve release in [the fourth quarter], which gooses net income for the quarter, for the annual result, and facilitates more ability to do share repurchases in [the first quarter]," Nerby said. That could leave banks with depleted credit and capital cushions and vulnerable to a range of negative scenarios, such as a major stumble in the distribution or effectiveness of the vaccine.