Bank stock valuations are excessively depressed right now on exaggerated concerns about future earnings and, frankly, poor analysis from the sell side. Bank managements need to communicate better to help alleviate this issue.
Some background: bank analysts have historically provided bad analysis during the downside of a credit cycle. They over-generalize, and really don’t understand all the effects that a falling credit cycle can have on a bank’s P&L. In particular, they (and regulators) initially overreact at the start of a downcycle, as companies typically build excessively high loan loss reserves. Then when the cycle turns, the excessive reserve-building becomes evident and reserve levels are brought down, sometimes through negative quarterly loan loss provisions.
What’s more, the adoption of CECL by banks has increased the level of confusion, and bad analysis by analysts, so that this cycle, the poor work done by analysts will likely end up being even worse.
For instance, let’s look at what would happen over the next year if there’s no meaningful change in the economic environment. Imagine a bank that sees no loan growth, no change in its loan mix, and no changes in the economic assumptions it used to establish its CECL loss reserve at the end of the second quarter. In this scenario, the company would record no loan loss provision in the upcoming quarters, since built into its CECL modeling would be a rising level of criticized loans, rising nonperforming loans, and a rising net chargeoff percentage. But would analysts be comfortable with the bank not adding new reserves as those credit metrics deteriorated? Of course not! They are going to complain as the reserve-to-classified-loan ratio goes down, the reserve-to-nonperforming-loan ratio is goes down, the reserve-to-total-loan ratio goes down, and say the company is “not covering” its net chargeoffs.
In the real world, of course, loan balances and mix will change and the economic forecasts will change, but my overall point is still valid. For decades, bank managements have allowed bank analysts to provide lazy and misleading analysis of banks’ credit quality.
So here’s my suggestion to bank managements: starting this month, in meetings with analysts and investors, managements should explain what is likely to happen to some of the popular shorthand measures of credit quality. The measures that some analysts use could deteriorate while credit quality is actually improving or staying the same. Managements should start by saying they will exclude these metrics from their press releases and take no questions about the company’s reserve-to-nonperforming loan ratio. It’s a worthless measure, as I have said for decades! It’s as helpful as measuring the loss reserve to the investment securities portfolio.
Bank managements, it’s finally time to lead the analysts! CECL and fiscal government programs have distorted credit metrics this cycle compared to past cycles. The costs of dealing with the credit problems of this cycle are wildly disconnected from traditional measures of credit problems. Bank managements need to lead!
Bank Managements Need to Lead Analysts on Credit, Not Follow
By Thomas K. Brown,
Bank stock valuations are excessively depressed right now on exaggerated concerns about future earnings and, frankly, poor analysis from the sell side. Bank managements need to communicate better to help alleviate this issue.
Some background: bank analysts have historically provided bad analysis during the downside of a credit cycle. They over-generalize, and really don’t understand all the effects that a falling credit cycle can have on a bank’s P&L. In particular, they (and regulators) initially overreact at the start of a downcycle, as companies typically build excessively high loan loss reserves. Then when the cycle turns, the excessive reserve-building becomes evident and reserve levels are brought down, sometimes through negative quarterly loan loss provisions.
What’s more, the adoption of CECL by banks has increased the level of confusion, and bad analysis by analysts, so that this cycle, the poor work done by analysts will likely end up being even worse.
For instance, let’s look at what would happen over the next year if there’s no meaningful change in the economic environment. Imagine a bank that sees no loan growth, no change in its loan mix, and no changes in the economic assumptions it used to establish its CECL loss reserve at the end of the second quarter. In this scenario, the company would record no loan loss provision in the upcoming quarters, since built into its CECL modeling would be a rising level of criticized loans, rising nonperforming loans, and a rising net chargeoff percentage. But would analysts be comfortable with the bank not adding new reserves as those credit metrics deteriorated? Of course not! They are going to complain as the reserve-to-classified-loan ratio goes down, the reserve-to-nonperforming-loan ratio is goes down, the reserve-to-total-loan ratio goes down, and say the company is “not covering” its net chargeoffs.
In the real world, of course, loan balances and mix will change and the economic forecasts will change, but my overall point is still valid. For decades, bank managements have allowed bank analysts to provide lazy and misleading analysis of banks’ credit quality.
So here’s my suggestion to bank managements: starting this month, in meetings with analysts and investors, managements should explain what is likely to happen to some of the popular shorthand measures of credit quality. The measures that some analysts use could deteriorate while credit quality is actually improving or staying the same. Managements should start by saying they will exclude these metrics from their press releases and take no questions about the company’s reserve-to-nonperforming loan ratio. It’s a worthless measure, as I have said for decades! It’s as helpful as measuring the loss reserve to the investment securities portfolio.
Bank managements, it’s finally time to lead the analysts! CECL and fiscal government programs have distorted credit metrics this cycle compared to past cycles. The costs of dealing with the credit problems of this cycle are wildly disconnected from traditional measures of credit problems. Bank managements need to lead!