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CECL reserve builds will prove inadequate, spur US bank earnings volatility

The Current Expected Credit Loss model could introduce more volatility in U.S. bank earnings as institutions seem unlikely to build their allowances enough to prepare for a looming turn in the credit cycle.

The new reserve methodology, commonly referred to as CECL, aims to speed up the recognition of losses and will require banks to set aside reserves for lifetime expected losses on the day of loan origination. However, since the industry has not yet seen any real credit deterioration, banks seem unlikely to reserve enough at adoption for the losses that could follow. That in turn could lead banks to record sizable provisions for losses as they occur.

Click here to read the full 2019 US Bank Market Report and to access data exhibits.

Click here for a U.S. banking industry projections template under our CECL scenario.

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Pristine credit today could prevent large upfront reserve builds

CECL compliance begins in 2020 for many institutions and marks a considerable shift from the current model, under which banks set aside reserves over time. The new provision will require banks to increase their allowance for loan losses on the date of adoption, resulting in a capital hit to the industry.

S&P Global Market Intelligence estimated the capital impact as part of our updated five-year outlook for the banking industry. Predicting the ultimate impact of CECL is difficult for various reasons. Banks will set aside reserves based on the loan type, the vintage associated with each credit and the current level of reserves tied to those assets. From there, banks will need to develop an opinion on the performance of each asset class and vintage.

However, it seems clear that loans with longer terms will require larger reserve builds since the current methodology requires banks to look ahead 12 to 18 months for losses after they are probable or have already occurred. Loans with far longer terms such as real estate credits could entail multiples of currently required reserves.

S&P Global Market Intelligence modeled CECL's impact on the industry, in part based on guidance provided by industry bellwether JPMorgan Chase & Co. The nation's largest bank said reserves could increase by $5 billion, or about 35%. In an adverse case, JPMorgan expects reserves to increase by $6 billion to $10 billion. We used the JPMorgan projection of CECL's day-one impact as a guide and developed two scenarios: an adverse scenario and a less severe scenario.

Major CECL scenario assumptions

➤ In the adverse CECL scenario, we assumed reserves would increase 65% at adoption. Under that scenario, as banks evaluated their portfolios in subsequent years and reserved for expected losses to comply with CECL, we assumed the credit cycle would begin to turn in 2020 and charge-offs would follow the long-term trend witnessed over the last 20 years.

➤ In the less severe scenario, we assumed reserves would increase 25% at adoption. Under that scenario, as the industry reserved for expected losses in subsequent years, we assumed institutions would look at historical experience during the brief recession in 2001.

➤Under both scenarios, we assumed the industry's outlook would adjust each year based on performance in the prior year.

➤Loan portfolios have a weighted average life of 3.5 years, based on the current loan composition across the industry.

➤Reserves equal cumulative net charge-offs in the 3.5 years after adoption.

➤All banking subsidiaries uniformly adopt the provision at Jan. 1, 2020.

➤Average life of loans: mortgages, seven years; multifamily loans, six years; commercial and industrial loans, 1.6 years; commercial real estate credits, 3.8 years; and consumer loans, two years.

The reserve increase should result in a manageable capital hit to banks, reducing the industry's tangible equity-to-tangible assets ratio by 39 basis points in 2020 under the adverse scenario and by 12 basis points under the less severe scenario. It is important to recognize, however, that the initial impact to regulatory capital will be phased in over four years, leaving the industry on more than adequate footing from a capital standpoint.

We assumed loan growth will be slower than it would have otherwise been as banks with thinner capital ratios hoard cash and work to rebuild their capital bases. We also expect that some banks will react to the change and raise rates on newly originated loans, particularly longer-dated real estate credits that will require a larger reserve build under CECL, but we have not incorporated those changes into our estimates.

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Credit quality slippage could lie around the corner

While credit quality has remained pristine in recent years, some economists see a turn in the credit cycle coming soon. The Wall Street Journal's monthly survey of more than 60 economists showed in February that 45.70% of respondents expect the next recession to occur in 2020, followed by 39.10% in 2021 and 10.90% in 2022. Just 4.30% of economists predict that a recession could occur in 2019.

Lenders are becoming more cautious, at least in certain asset classes. Spreads on commercial and industrial credits have been under pressure for much of the last nine years, but the trend showed signs of changing. In the Federal Reserve's recent quarterly senior loan officer survey, bankers said spreads on C&I credits to larger and middle-market firms, relative to their cost of funds, expanded in the first quarter, ending 35 straight quarters of weakening spreads. That survey featured responses from 73 domestic banks and 22 U.S. branches and agencies of foreign banks and focuses on changes in lending standards and terms.

In the survey, a net 4.2% of banks responding reported stronger spreads on C&I loans to large and medium-size firms, relative to the lenders' cost of funds. That compares to 26.5% of respondents reporting weaker spreads in the previous quarterly survey, published in October 2018.

While spreads expanded in the most recent period, banks reported weaker demand for C&I loans from large and middle-market firms for the second consecutive quarter.

The recent period of weakening spreads marked the longest since the survey began recording the metric in 1990. The next-longest stretch was 24 quarters between the fourth quarter of 1992 and the third quarter of 1998, several years before the U.S. economy entered into a brief downturn. More recently, banks eased standards for 17 quarters stretching from the third quarter of 2003 to the third quarter of 2007, right before the onset of the Great Recession.

Changes in the competitive environment have come as short-term interest rates have risen considerably over the last 18 months, increasing the cost of debt service for borrowers. The higher costs could be enough to push some borrowers to the brink or, even worse, into default.

This has occurred as global economic growth has slowed. The risk that slower growth abroad could pose to the U.S. economy recently pushed the Fed to take a more dovish stance.

If economic growth slows and credit quality slips, the U.S. banking industry could experience depressed returns in 2021 since CECL will require banks to reserve for the full life of loans. As credit quality is expected to slide early in 2020 and dip further throughout the year, banks could experience sizable provisions in 2021 under both the adverse and less severe scenarios, resulting in weaker returns.

Those reserve builds could leave banks slightly better positioned for peak losses as they materialize in 2022 and 2023. The credit environment is expected to improve from that point and accordingly could allow the industry to record smaller provisions when losses are elevated but have shown signs of stabilizing.

However, in either case, earnings would be more volatile since banks would not have reserved enough, up front, for a downturn that could begin in the middle of 2020. If that plays out and banks have only recorded modest reserve builds at CECL's adoption, they will have to play catch-up as portfolios season and losses rise.

Scope and methodology

S&P Global Market Intelligence analyzed nearly 10,000 banking subsidiaries, covering the core U.S. banking industry from 2005 through 2018. The analysis includes all commercial and savings banks and savings and loan associations, including historical institutions as long as they were still considered current at the end of a given year. It excludes several hundred institutions that hold bank charters but do not principally engage in banking activities, among them industrial banks, nondepository trusts and cooperative banks. The analysis divided the industry into five asset groups to see which institutions have changed the most, using key regulatory thresholds to define the separation. The examination looked at banks with assets of $250 billion or more, $50 billion to $250 billion, $10 billion to $50 billion, $1 billion to $10 billion, and $1 billion and below.

The analysis looked back more than a decade to help inform projected results for the banking industry by examining long-term performance over periods outside the peak of the asset bubble from 2006 to 2007. S&P Global Market Intelligence has created a model that projects the balance sheet and income statement of the entire industry and allows for different growth assumptions from one year to the next.

The outlook is based on management commentary, discussions with industry sources, regression analysis, and asset and liability repricing data disclosed in banks' quarterly call reports. While taking into consideration historical growth rates, the analysis often excludes the significant volatility experienced in the years around the credit crisis.

The projections assume future Fed funds rates and 10-year Treasury yields based on a monthly survey of more than 60 economists conducted by The Wall Street Journal. Interest rate assumptions for 2022 are based on a two-point average of the WSJ survey and estimates from the Congressional Budget Office's annual outlook. Figures for 2023 are based on CBO estimates. S&P Global Market Intelligence does not forecast changes in interest rates or macroeconomic indicators and aims to project what the banking industry will look like if the future holds what most economic observers expect.

The outlook is subject to change, perhaps materially, based on adjustments to the consensus expectations for interest rates, unemployment and economic growth. The projections can be updated or revised at any time as developments warrant, particularly when material changes occur.

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