Over the past several weeks I have provided a downbeat---but realistic---view of the economy. The unemployment rate in April spiked to 14.7% and will come in closer to 20% for May. GDP will contract by more than 20% at an annualized rate in the second quarter. Banks’ provisions for loan and lease losses in the first quarter increased substantially, but part of this was due to the adoption of a new accounting standard.
Beginning with first-quarter 2020 results publicly held banks are required to use the Current Expected Credit Loss (CECL) standard. CECL requires banks to hold allowances for loan and lease losses based on expected credit losses over the life of each loan it holds. Previously, banks took provisions based on the historical performance of loans. With CECL banks use credit risk models along with economic forecasts to revise their estimates of future credit losses. The legacy ALLL methodology tended to incorporate many manual adjustments and discretion. CECL attempts to rectify that shortcoming, as CECL is automated in that the calculations derive from credit risk models that are fed relevant loan information and macroeconomic forecasts. Of course, economic forecasts themselves can be volatile, especially in treacherous times like now, but rules and other details of how the forecasts are incorporated mitigate some of that volatility.
How much of the increase in allowances is due to the accounting standard, and how much is due to the worsening economic outlook?
I searched through several of the largest banks’ 2020 Q1 earnings releases to answer that question. Most of them included a table labeling provisions due to CECL as a separate line item. Other banks provided enough information that we could estimate the effect of CECL based on other figures. Table 1 shows my results.
The last column of table 1 indicates the proportion of total provisions taken throughout 2020 Q1 that can be attributed to the adoption of CECL. As a whole, about 38% of 2020 Q1 provisions are due to CECL. Wells Fargo stands out because adoption of CECL let it release more than $1 billion from allowances. According to its 2020 Q1 earnings statement, the release was because of commercial loans with shorter maturities; consumer lending required additional provisions, as with all the other banks considered here. Truist also stands out, though I suspect this could be merger related as the company chooses among legacy Suntrust and BB&T credit models to score the combined portfolio.
We cannot say that as a whole 62% of 2020 Q1 provisions are due to the worsening economic environment, because some of those provisions reflect the expected lifetime credit losses of new loans issued throughout 2020 Q1. Nevertheless, comparing 2020 Q1 provisions to ALLL balances as of 2019 Q4 shows that banks are expecting large credit losses throughout the remainder of the year.
Going forward, quarterly provisions will stem from two sources. First, as new loans are underwritten, provisions against their expected credit losses will be taken. Second, provisions will be taken as the economic outlook changes, and in particular if that outlook over the next few years deviates from the economy’s long-run trend. Given the already dire economic projects available at the end of March and early April, it will be interesting to what happens to provisions when second-quarter results are released in July. One complication is that the CARES Act passed at the end of March to alleviate the fallout from COVID19 includes a provision such that certain banks that were to adopt CECL at the beginning of the year are now able to wait until 2021.