The coronavirus pandemic forced most banks to set aside much more in reserve than usual to prepare for potential loan losses. After all, the pandemic resulted in broad swaths of the economy shutting down for long stretches and the overall economy running at a much slower pace than normal. But intervention from the Federal Reserve and the U.S. government has delayed those loan losses and might even prevent them from happening. If more stimulus is passed and vaccination efforts prove successful, Fifth Third Bancorp (FITB -2.05%) is likely to benefit in an outsized way because of all of the reserves it has built up. This, in turn, could lead to much better earnings in 2021. Here's why.

Building that says bank.

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Massive reserving, but few losses

Fifth Third has taken a conservative approach to its loan loss reserving. At the end of the fourth quarter, the $205-billion-asset bank had reserved $2.6 billion, or enough money to absorb losses on roughly 2.41% of its loan book and unfunded lending commitments.

There are two important things to remember about these reserves. First, banks reserve capital in advance for losses that they expect in the future. This money comes out of earnings each quarter as a provision and is moved into the overall loss reserve bucket called the allowance for loan or credit losses. So the money put into this allowance bucket is not actually lost yet -- if those loan losses do not materialize, banks can release reserves and add them back into earnings as a negative provision on the income statement.

Second, at the beginning of 2020, most large banks adopted the new current expected credit losses (CECL) accounting methodology. This method requires banks to reserve for losses on the entire life of their existing loan book even if they have no reason to believe at the time that certain borrowers will go into default. CECL hit banks' balance sheets almost at the same time as the pandemic did (talk about a double whammy), so loan loss reserve levels have been all over the place as the industry dealt with a new accounting method and an unprecedented pandemic.

Between the end of 2019 and the first quarter of 2020, Fifth Third saw its total allowance for loan losses jump from $1.3 billion to roughly $2.5 billion, almost doubling, to account for CECL and potential future losses from the pandemic. As 2020 progressed, Fifth Third's total reserves held somewhat steady, ending the year at about $2.6 billion. But during this time, the economic outlook improved significantly because of government intervention. This made the initial amount of loan losses the bank may have been projecting much more unlikely.

The losses may not materialize

Fifth Third is currently projecting charge-offs (debt unlikely to be collected, a good representation of losses) to peak in 2021 somewhere between 0.45% and 0.55% of total loans. That means Fifth Third's current reserves (2.41% of loans) can cover nearly five times the net charge-offs the bank expects to materialize. The bank's modeling behind this factors in the $900 billion stimulus bill passed in December, but not stimulus currently being proposed by President Joe Biden. If some form of that stimulus passes, peak charge-offs will likely be in the lower end of the bank's estimated range or maybe even below it.

Fifth Third CFO Jamie Leonard said the bank's modeling is based on economic scenarios from Moody's that include a base case that is more severe than the bank's current outlook. The base case assumes unemployment ends 2021 at 7.2%, which would be higher than it is now. The modeling also includes a slight weighting to a more severe scenario than the base case that the bank doesn't expect to happen. All of this pushes up the bank's reserve levels. Even if Moody's base case pans out, Leonard said you can expect the bank to release $200 million of reserves from its current levels.

But even that could be conservative. On the first day CECL was implemented in 2020, Leonard said the bank's total reserve allowance was 1.82%. Now, Leonard said he is not sure the bank will return to the day-one CECL reserve level any time over the next few years. But a $200 million release would only push the bank's total reserve allowance down from 2.41% to roughly 2.2% of total loans if we use the bank's current outstanding loan balance. That still leaves a lot of room above the day-one CECL reserve level.

A nice boost to earnings

Leonard said the bank is not predicting or forecasting reserve releases at this point. But if we stay on this track with vaccines and more stimulus passes, I would say that the $200 million release is more likely to happen than not. If we assume the bank has the same outstanding share count (713 million) as it does now -- this is very unlikely because the bank intends to buy back shares, reducing the share count -- the $200 million release would translate to a positive earnings impact of $0.28 per share. Obviously, there are several factors at play, but as you can see, it could have a sizable impact considering the bank reported $3.33 earnings per diluted share in 2019 and $1.83 in 2020. 

Recently trading around 140% of tangible book value, Fifth Third's stock has bounced back considerably. But given how over-reserved the bank is and its conservative outlook, there could definitely still be upside.