With the first quarter of the year now in the books, all eyes are turning toward bank earnings reports, most of which will come out in April (unless some banks delay reporting). This particular quarter will be highly scrutinized because the initial impact of the coronavirus pandemic will begin to be reported. Everyone suspects earnings are going to take a hit, but no one really knows to what extent considering the unprecedented economic scenario the world finds itself in.

It will be interesting to see how banks' balance sheets fare from all of the expected mortgage deferments, businesses requesting extended lines of credit, and higher loan loss reserves. Analysts at Keefe Bruyette & Woods cut earnings estimates on March 31 for "universal banks" by 58% for 2020 and 50% for 2021, citing rising unemployment, increased loan losses, and low interest rates that cut into net interest income. This is the first big economic test for banks since the Great Recession and since significantly enhanced regulatory rules requiring banks to hold much larger amounts of capital were enacted.

Here is what to keep an eye on as banks report Q1 earnings reports.

Bank sign on the front of a bank branch.

Image source: Getty Images.

Asset quality

Regardless of economic conditions, asset quality is always one of the most, if not the most important, metrics to look at when it comes to a bank. Plain and simple, the main way banks fail is by loaning out money that never gets repaid. Additionally, a small uptick in the loan loss reserves, cash that banks keep on hand to stomach projected loan losses, cuts directly into banks' profits. For instance, let's say a bank has a $100 million loan portfolio with a 5% spread. Earnings on that portfolio are expected to be $5 million (100 x 0.05). So it only takes one $5 million loan to go into default to erase all of the expected income in the entire $100 million portfolio.

There is little doubt that loan loss reserves are expected to increase in Q1. Investors should ask by how much and also try to understand the thinking that went into the calculation. Is the bank exercising conservative judgment and preparing for a doomsday scenario just in case? Or does it believe that most loan issues are temporary and will recover? Knowing the methodology behind the reserve number will help you better understand the impact the pandemic has had on the bank and the financial strength of the bank.

Coronavirus information

This will be the big question in most earnings: How much information are the banks going to provide regarding the extent to which their portfolio has been impacted by the coronavirus pandemic? Recently, the banking regulatory agencies issued a statement saying that banks do not have to categorize loans modified as a result of the coronavirus as troubled debt restructurings (TDRs). When a borrower is experiencing financial difficulty, banks can modify the terms of the loan to provide a concession to the borrower. They put those loan modifications into a bucket on the balance sheet called TDRs. Investors and analysts can use this to get an idea of what could be coming down the road.

It makes sense for government regulators to grant this relief given the situation, but that leaves uncertainty about how to figure out how many loans are affected by COVID-19. It also leaves questions like: How many mortgages are being deferred, and what do those deferment plans look like? How many businesses are putting off loan payments? In a recent statement, Securities and Exchange Commission Chairman Jay Clayton encouraged public companies to provide as much information as possible on how operations and the future are coronavirus-related.

Who's using CECL

Because of economic conditions, banking regulators also said they would allow banks to delay the impact of the new current expected credit losses (CECL) accounting method for another two years. Put into effect on Jan. 1, CECL requires banks to report expected losses on the life of a loan as soon as that loan is originated and put onto the balance sheet. The measure is expected to increase loan loss reserves at many banks, particularly at the larger banks, which again directly impacts earnings.

Although banks can delay the impact of CECL, some might very well implement it anyway because they were likely ready for the change, considering the delay happened very recently. If a bank is not applying CECL, its loan loss reserves are likely to be lower than they would be under CECL. Also, implementing CECL could be a sign of financial strength, considering the bank is moving ahead with an accounting policy it knows will make it look worse in an already difficult time.

Refinancing activity

Don't expect a ton of positives in Q1 earnings reports, but refinancing activity could be one area of growth. Because the Federal Reserve cut interest rates, that ultimately sent long-term mortgage rates lower, triggering homeowners to refinance their mortgages to lock in at lower interest rates. Although the process reduces monthly loan payment amounts to banks, it results in an increase in application and closing fees.

Understand that nothing is certain

Although it's tempting, don't put too much weight into these earnings reports as a factor in your investing decisions. Banks are dealing with a scenario they have never seen before, and they have had very little time to do an insane amount of work to address the changes. The winning banks won't be known until later this year or next year. Understand that just because a transaction is recorded on paper, that doesn't mean it's the final result. Even after banks record charge-offs (debt on loans unlikely to be recovered), it is not uncommon for them to recover a portion of those charged-off loans over the next few quarters. Just try to use these first-quarter earnings reports as a peek into how banks are dealing with the early fallout from the coronavirus.