For Banking Investors, Credit Is Due

A change in loan-accounting rules may shift the focus from rates to credit for bank stocks, especially consumer lenders

By Telis Demos




Credit risk was mostly a nonfactor for banking investors in 2019. It was all about interest rates.

The new year might be a different story.

This isn’t to say that the long-awaited “normalization” of default rates on loans to consumers and businesses will suddenly arrive, at least not without an accompanying recession.

But a technical tweak to the way lenders account for loan losses will nevertheless force investors to reckon with banks’ long binge on consumer credit, and what that might mean over a complete economic cycle.

Starting in 2020, most big lenders will have to follow a new standard for how they reserve for potential losses on loans, called current expected credit loss, or CECL. Previously, when lenders booked new loans, they typically reserved capital for anticipated losses over the next 12 months. Under CECL, they will have to reserve for expected losses over the lifetime of the loan.

In practical terms, that will mean noisy first-quarter 2020 earnings reports, as lenders make one-time adjustments to reserves. Analysts at Keefe, Bruyette & Woods forecast a median 36% reserve increase for the companies they cover, translating into a 7% increase in 2020 provision expenses, and around a 1% drag on earnings per share. But in economic terms, CECL only shuffles the timing of reserves, not the ultimate amount, to say nothing of realized losses. From a long-term investors’ perspective, it is in theory a wash.

So investors wouldn’t be totally misguided to mostly ignore all of this—as long as the lender can absorb the hit to capital without needing to raise more equity to meet regulatory requirements.


Share prices of a group of the largest consumer-lending banks—such as Capital One Financial, Discover Financial Services and Synchrony Financial—rose about 30% in 2019. Photo: Rachel Wisniewski for the Wall Street Journal


There is a bit more to the story, though. From now on, new loans will require more reserves upfront. Banks that are counting on operating at a level close to their regulatory capital minimums might have more trouble managing to these levels, either affecting their ability to return capital or to make new loans.

In addition, estimates of required reserves will continue to fluctuate, despite banks’ best estimates of their potential lifetime losses. As Morgan Stanley banking analysts put it in a recent note, “banks do not have perfect foresight.” Morgan Stanley and other analysts believe CECL could actually increase the volatility of reserve levels during economic downturns as banks are forced to make quicker adjustments to their estimates.

It also is worth considering where the credit cycle stands. Normally, the impact of CECL might be somewhat muted, since riskier loans are mostly short-term anyway—asking banks to reserve for the whole length of the loan doesn’t change that picture dramatically. But with lenders having enjoyed a long, placid cycle, they are now doing things like extending the duration of auto loans by years, and making more unsecured personal loans that usually go to lower-rated borrowers. So this might be an especially touchy time to start turning over rocks in loan and card books.

Amid a party atmosphere in financial stocks, it has been easy to miss the growing concern about consumer loans. Share prices of a group of the largest consumer-lending banks—such as Capital One Financial, Discover Financial Servicesand Synchrony Financial —rose about 30% in 2019, roughly matching the rise in the KBW Nasdaq Bank index.

But as a group they are actually trading at a relatively sharp discount—about 8.6 times forward earnings, versus their five-year average of 9.9 times. Meanwhile, S&P 500 banks average 12.1 times, versus their five-year average of 11.5 times.

Simply scrutinizing loans won’t make them any more likely to default. Still, investors should be ready for what things at the party look like when the lights are turned on.

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