How a New Accounting Rule Is Making Bank Earnings Go Wild

Net income doesn’t mean it ever was.

Since the start of 2020, bank profits have been volatile, reminiscent of the financial crisis. Banks have faced a global pandemic, a sharp but short-lived recession and an economy rife with unusual wrinkles, but fluctuating profits say their revenue remains unchanged and stable performance.

The culprit is the accountant. Banks are now nine-quarters into a new set of rules governing how they prepare for potentially loss-making loans. This shift forces them to quickly build up reserves when they’re worried about the pandemic — only releasing those funds when the damage doesn’t materialize.

In the five years before the new regulations were introduced, the banking industry’s total quarterly net income changed only a small amount each quarter. The average change was a 6% increase year-over-year, excluding the impact of 2017 tax changes, according to data from the Federal Deposit Insurance Corporation.

Since the beginning of 2020, banks have achieved an average increase of 53%. The banking industry’s full-year profits fell 70% in the first quarter of 2020 and again in the second quarter. They grew more than 300% in the first quarter of 2021.

Big swings reduce the usefulness of net income as a measure of a bank’s performance, although it remains at the core of many stock valuations.

“We don’t see it as profit. It’s ink on paper. “JP Morgan Chase JPM 1.61%

& Co CEO Jamie Dimon said in early 2021 after the bank released $4 billion from reserves and profits jumped 42%.

The new accounting standard, known as expected current credit loss, or CECL, says that a bank must set aside funds to cover loan losses that may occur at any time in the future. future. That’s a much broader calculation than the old rules, based on impending projected losses. The rule is intended to create a clearer picture of bank risk by forcing banks to acknowledge potential problems sooner. The Financial Accounting Standards Board adopted CECL in 2016, spurred on by criticism that banks were recording losses too slowly before the 2008 financial crisis.

Bankers say the shift magnifies the impact of economic cycles. They determine their provisions by weighing a variety of economic forecasts and then modeling how their loans will perform. If the forecast is more bleak for a quarter, banks will have larger reserves. A quarter with clearer economic skies will cause them to release reserves.

In early 2020, there was a real fear that loan losses would spike. The unemployment rate, often a leading indicator for debt defaults, has risen sharply. The business has ceased operations and has no revenue. Banks have made provisions for loan losses and interest reductions.

‘We don’t see it as profit. It’s ink on paper,’ JPMorgan CEO Jamie Dimon said in early 2021 after the bank released $4 billion from its reserves and profits jumped 42%.


Image:

BRAN SNYDER / REUTERS

But then the government stepped in and passed stimulus measures to put cash into bank accounts. Net offsets, the amount banks no longer expect to collect from loans, have fallen. Banks have drawn billions of dollars from reserves in 2021, driving profits up.

“What kind of accounting is that?” Mr. Dimon said on Wednesdayat an investor conference. “I think that’s crazy.”

Banks and other companies are often judged on how their earnings compare to analyst expectations. Accounting changes also affect that relationship.

In the five years before the rule change, analysts were pretty tight-lipped in forecasting the earnings of the four biggest banks: JPMorgan, Bank of America Corp., Citigroup. Inc.

OLD 0.08%

and Wells Fargo WFC 0.38%

According to FactSet data, banks beat analysts’ estimates by about 4.5 percent.

As of 2020, these major banks have beaten their consensus estimates by an average of 34%.

Net income remains a broad measure of profit a bank can use or return to shareholders. But analysts tend to focus on numbers that exclude loan exposure. Citigroup analyst Keith Horowitz said investors with long-term bets on banks should consider the regulatory terms of the banks’ forecasts.

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“The most important thing on earnings day is what you’re telling me about future earnings potential,” says Mr. Horowitz. “It’s a barometer of where the banks are going.”

Discussion of the next recession could prompt more accounting fees this year.

In the first quarter, JPMorgan surprised analysts with a $900 million increase in reserves. Executives are bracing for a slight increase in the probability of a recession, although they are not predicting it. Bank profits fell 42%.

Write letter for David Benoit at david.benoit@wsj.com

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https://www.wsj.com/articles/how-a-new-accounting-rule-is-making-bank-earnings-go-wild-11654248780?mod=rss_markets_main How a New Accounting Rule Is Making Bank Earnings Go Wild

Edmund DeMarche

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