Wells Fargo Has Billions of Dollars Left to Release Back Into Earnings

After building up billions of dollars in reserves last year to prepare for loan losses from the pandemic, most banks have been releasing reserves back into earnings as profits over the last few quarters, largely because the losses that were expected never materialized. But one bank that has been slower on the reserve releases is Wells Fargo (WFC 1.36%). That's why when CEO Charlie Scharf told investors at an industry conference in June to expect a "significant reserve release" in the second quarter, I was expecting something pretty big considering how much Wells Fargo has built up reserves, and with the greatly improving credit outlook.

But instead, the bank released a much smaller amount than I anticipated. This isn't necessarily bad news considering the bank had a decent quarter, but it means the bank has potentially billions left to release into earnings if the economy stays on its current trajectory.

Slacking on reserve releases

On an improving economic backdrop and the deployment of COVID-19 vaccines, banks began releasing reserves in the fourth quarter of 2020, so there have really been three quarters of releases now for a lot of banks. Here is how much each of the big four banks have released from reserves since Q4 of 2020 on a gross basis.

Data source: Bank financial statements.

As you can see, Wells Fargo has released $1.7 billion less than its next closest peer, Bank of America. And in the fourth quarter of 2020, it only released $757 million because it sold its student loan portfolio. The disparity doesn't make a whole lot of sense to me right now because Wells Fargo arguably has some of the best credit quality of these four banks. Look at net charge-off rates (debt unlikely to be collected and a good indicator of actual losses) for these four banks at the end of the second quarter.

Data source: Bank financial statements, Cap IQ.

Additionally, nonperforming assets, those in risk of going into default, are also down at Wells Fargo from the first quarter. While you never know the whole credit picture, there is nothing that would lead me to believe that credit conditions are different at Wells Fargo than at any of these other banks. Scharf said the bank was keeping reserves high to account for risks and uncertainty that are still in the environment, but added that if things keep progressing, there should be future reserve releases.

Image source: Wells Fargo.

How much could Wells Fargo still release?

The short answer is a lot. A key credit-related metric to watch at banks is called the allowance for credit losses (ACL), which is a measure of how much capital banks have in reserves for loan losses as a percentage of their total average loans and other commitments. The ACL obviously increased a lot during the pandemic, but it has since come down as banks released reserves. Still, many banks' ACLs remain above where they were prior to the pandemic.

We can look at the ACL at the end of the second quarter and compare it to what it was at prior to the pandemic to get an idea of how much reserves banks could still release. Although keep in mind they may not ever fully get back down to that pre-pandemic level.

Data source: Bank financial statements *Rough calculation.

Wells Fargo has the largest cushion above its ACL prior to the pandemic. Currently its ACL is 1.92% of average loans versus 0.90% prior to the pandemic, and credit metrics are better now than they were before the pandemic. There are still uncertainties related to the pandemic, and credit quality could deteriorate once stimulus money runs down and interest rates rise, but ACLs are still currently accounting for losses that are no longer expected to materialize.

If you look at Wells Fargo from a dollar perspective, the bank's ACL at the end of the second quarter was nearly $16.4 billion, while its ACL prior to the pandemic would have been $9.3 billion, meaning the bank is currently reserved by more than $7 billion over ACL levels prior to the pandemic.

A boon for earnings

Given the pace management is going with reserve releases, don't expect this to happen all at once, but more gradually over the next year reserves should keep coming down as long as the economy keeps moving in a positive direction. Loan growth may offset some of the release and I doubt Wells Fargo will ever get down to that $9.3 billion level, as it will always want to keep some buffer to account for uncertainty.

But remember, Wells Fargo is also currently limited in how much it can grow its balance sheet due to the $1.95 trillion asset cap currently in place. So I think billions more from reserves are likely to be released back into earnings over the next year, which should add nicely to profits.