Banks Are Building Reserves for a Potential Recession -- How Bad Do They Think It Will Be?

Banks may hold the key to understanding what could happen next in the economy. As some of the first companies to report earnings in 2023, the major banks provided insight into what could happen -- including the prospects of a looming recession.

There's been a lot of talk about a potential recession; in a recent survey by Bloomberg, four out of five economists expect a recession in the next 24 months. Banks like JPMorgan Chase (JPM 1.44%) and Bank of America (BAC 1.70%) have been preparing for a potential downturn by bulking up their reserves, including large buildups in the fourth quarter. How much have banks added, and how severe do they think a recession will be? Read on to find out.

Why do banks save for potential losses and how does it affect their earnings?

Banks accumulate credit reserves as a way to protect them against losses. In 2020, the Financial Accounting Standards Board implemented new accounting standards called the current expected credit losses (CECL) method. The CECL method requires banks to reserve losses on the life of a loan as soon as it hits its balance sheet. Banks must reserve these losses even if they don't expect credit losses immediately, and use historical experience and current conditions as the basis of their estimates. 

The provision for credit losses is an item on the income statement representing the amount of loss reserves built up (or released) during the period. Banks will set aside funds when there is uncertainty in the economy or when credit quality begins to deteriorate, which occurs when past-due accounts or charge-offs start increasing.

When banks set aside these funds, it's known as a reserve build and results in a charge on the income statement, which can reduce earnings. When the economic outlook brightens, banks can decrease these funds, known as a reserve release, and that can boost earnings.

Here's how much those major banks are setting aside

Bank reserves have fluctuated wildly in recent years, beginning with the pandemic in 2020. The pandemic brought along lots of uncertainty about the global economy, and banks built up massive reserves in preparation for this time. For much of 2021, banks released these reserves as countries reopened and economies began normalizing.

In 2022, banks began building up reserves once again, this time due to economic uncertainty around inflation and rapidly rising interest rates and the potential impact on the economy. All of the major U.S. banks added to their reserves in the fourth quarter.

JPMorgan Chase, the largest U.S. bank by assets, built up $1.4 billion in reserves and had another $887 million in net charge-offs, giving it a provision for credit losses of $2.3 billion during the quarter. Bank of America built up reserves of $403 million and had charge-offs amounting to $689 million, resulting in a provision for credit losses of $1.1 billion in the quarter. Wells Fargo and Citigroup also build up reserves of $397 million and $640 million in the quarter. 

Bank leaders see this type of recession

The banks gave a few reasons for the quarter's reserve increases. For one, loans have been growing at a faster pace, especially credit card balances. For example, JPMorgan Chase card loans grew 19% in the fourth from a year earlier. Meanwhile, outstanding credit card balances at Bank of America were up 14%. This shows consumers are using credit cards more to fund their purchases, and banks are building up reserves as loan balances grow to account for this.

Another reason for the reserve growth is a modest deterioration in the bank's macroeconomic outlook. According to JPMorgan Chief Financial Officer Jeremy Barnum, the bank's central case sees a mild recession and unemployment peaking at just under 5%. Brian Moynihan, chief executive officer of Bank of America, agrees with the mild recession call, and the bank expects unemployment to peak at about 5.5% and remain above 5% through the end of 2024. 

The major banks expect a recession, but they don't believe it will be bad. Consumers still have strong balance sheets, and while net charge-offs and delinquencies are rising, they remain below historical averages. On a positive note, if we get a mild recession that also brings down inflationary pressures, it could accomplish the Federal Reserve's mission of a soft landing, which may well set the stage for the next bull market run.