One of the main reasons the banking sector has struggled more than others during the coronavirus pandemic is because investors and analysts have had difficulty understanding the underlying risk in bank portfolios. The odd nature of the coronavirus pandemic, along with lots of government intervention and the uncertainty ahead, have masked the true quality of credit. Loan losses have not materialized like they normally would during a recession, but banks have added to their reserves heavily, projecting that the losses will eventually roll in.

Many bank management teams in the third quarter took actions and made statements that would suggest they were feeling better about their portfolios and the economy, even as the country heads for what many are expecting to be a tough winter. Can banks really be feeling better about credit quality with coronavirus cases surging?

Generic bank

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Do the numbers and sentiment add up?

Banks have added to their reserves significantly to prepare for future potential loan losses, but now many management teams don't expect to see these losses show up until the back half of 2021. This makes a certain amount of sense because banks aren't seeing a lot of new delinquencies, and they typically won't charge off most loans, or deem the debt to be uncollectible, for 180 days. At the same time, comparing some banks' total reserves to management's projections on loan losses, it can be difficult to understand how the two support one another.

For instance, Fifth Third Bank (NASDAQ:FITB), a roughly $180 billion asset bank based in Cincinnati, has set aside enough reserves to cover loan losses equating to 2.49% of its total loans. Yet Fifth Third CEO Greg Carmichael said on the company's recent earnings call, "Looking ahead to 2021, we continue to expect full-year net charge-offs to come in well below 1%." That means the bank has more than double the reserves it thinks it ultimately needs. If it really feels that confident about projected charge-offs, why does it need all of those reserves?

Then take another regional bank, like the $60 billion asset People's United Financial (NASDAQ:PBCT), which has built enough reserves to cover losses on 0.94% of total loans. That seems to be toward the lower end of reserving when you look at comparable banks, especially since People's United has more than 75% of its loan book in the commercial sector. But management expressed confidence in their reserving methodology, so I guess you could say the numbers and sentiment do align here. Still, despite the disconnect, I still feel better about Fifth Third's reserving because I'd rather have a bank that feels really good about credit but is still over-reserved right now, given all of the uncertainty.

Several banks, including Fifth Third, also released reserves back into earnings during the third quarter, suggesting that economic conditions may be looking better than they thought, an idea that had some analysts skeptical. "Do you really want to set a tone at this stage of the cycle of taking a negative provision? I mean, you might be right, but you might be wrong, but we don't really know how this is going to play out," said analyst Mike Mayo on Fifth Third's third-quarter earnings call.

In fairness, it is extremely difficult for anyone to have certainty right now. For the first time, banks are using a new accounting system called the current expected credit losses (CECL) methodology, which has them project losses over the life of loans as soon as they come onto the balance sheet. That essentially front-loads reserves. At the same time, the Federal Reserve's actions and government intervention have really stretched the timeline of loan losses, so banks now have reserves on their books they may not need to use for months -- maybe even more than a year. A lot can change in that time frame.

What to make of it

I can understand banks feeling better about economic conditions. Another round of stimulus is likely coming at some point, even if it's after the election. And the personal savings rate is much higher, as are deposits across the banking system, suggesting consumers and businesses are preparing for uncertainty.

Where I would caution is on listening to projections that are too far in the future, given how quickly things have changed. While many bank management teams seem to be thinking conservatively, and are not accounting for a second round of stimulus in their modeling, I am not sure if banks have prepared for the absolute worst-case scenario, like, say, if there is another round of shelter-in-place orders, or much more muted economic activity in general. In the second quarter of this year, GDP declined by more than 30% and banks heavily built their reserves. Now, that may not happen again, but at this point it's hard to rule anything out for sure.