The dominant storyline of 1st quarter bank earnings was the massive build in Current Expected Credit Losses (CECL). Banks take these charges against net income to build reserves in anticipation of loans going sour in the future. This storyline persisted into 2nd quarter earnings as banks continued bolstering these reserves to a level in excess of analysts’ expectations. It should be noted that these are reserves, not actual charge offs, as delinquencies have only grown nominally.  The true cash impact to a bank will not be known until there are actual delinquencies on loans.  If realized charge offs are lower than expected, this will provide a boost to bank earnings in the future as reserves are reversed.

JPMorgan built its reserves by $8.9B and now has $34B in firm wide reserves, up from $14B at the end of 2019. Bank of America, Citigroup, and Wells Fargo all similarly built their reserves by $4B, $6B, and $8B respectively. These reserves count against earnings and significantly lower a bank’s reported net income. Even though unemployment is trending down and consumer spending is trending up, the building of reserves is justified.  As Jamie Dimon, JPMorgan’s CEO, said, “We still face much uncertainty regarding the future path of the economy.”

Another story from 2nd quarter bank earnings has been huge growth in investment banking revenue. The Federal Reserve has injected massive amounts of liquidity in the system, resulting in interest rates falling.  These lower rates and heightened uncertainty encourage companies to raise cash. In order to raise the cash, companies hired investment banks to arrange the deals. As a result, JPMorgan and Bank of America both saw investment banking revenue grow over 50% to new records.

The unexpected gains in investment banking revenue offset some of the losses from the higher credit provisions, nicely allowing banks to beat EPS estimates. As mentioned, the building of reserves seems justified, given the many current unknowns. But they also represent a potential gain down the road.  If a bank’s assumptions were too aggressive and it builds too much in reserves, it can reverse the charge in subsequent quarters. All else being equal, the reversal will increase EPS and cause the bank to beat estimates. In the 1990s, several studies showed banks used Loan Loss Provisions to manage earnings. This quarter may have presented a similar opportunity. Take a large charge in one department, knowing it will be offset by strong performance in another department, and overall earnings still look strong.

Through two quarters of bank earnings in a COVID world, we know they are preparing for the worst. However, they are most likely hoping for the best, knowing that will mean strong earnings when the dust settles.