US banks face uncertainty around potential loan defaults

•  Loans under deferral at the biggest US banks more than halved in Q3, and they reduced loan loss reserves accordingly.
• But as coronavirus cases spike and customers’ true financial situations remain unclear, banks may not be able to maintain these lower levels through Q4.
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Loans under deferral at the biggest four US banks plunged from $190 billion in June to $90 billion as of September 30, but it is uncertain whether they will continue declining in the coming months, according to Financial Times analysis of regulatory filings. The Q3 decline owes to consumers and businesses resuming payments as the economy began to reopen and social distancing measures eased in many regions. But spiking coronavirus infection rates across the US have raised concerns that the dip in deferrals could only be temporary.

US banks pulled back on loan loss provisions across the board in Q3, suggesting confidence in customers’ improving financial situations—but gauging the level of risk they face remains a challenge. Bank of America (BofA), Wells Fargo, Citigroup, and JPMorgan Chase have taken more than $62 billion in charges in total for future loan losses this year, largely in the first two quarters, per the FT.

They tapered back their allocations in Q3, as more customers exited deferral programs and resumed regular payments: BofA, for example, set aside $1.39 billion for loan losses in Q3, far lower than the $5.12 billion it allocated in Q2. But offering widespread forbearance as a relief option during the pandemic has led to uncertainty for banks, as they struggle to gauge which customers opted into forbearance out of need—and thus are at a high risk of ultimately defaulting on their loans—versus which customers did so to build up a safety net or just to get a break from regular payments.

Despite the downward trend of deferrals in Q3, we think the trajectory of the pandemic will ultimately determine how much the major US banks set aside in loan loss provisions. Coronavirus cases are spiking across the US, with a single-day record-breaking total of over 140,000 reported earlier this week, per CNN. With that has come skepticism over consumers’ continued ability to resume regular payments—and whether banks will continue to lower their loan loss reserves: The Federal Reserve recently warned banks that major debt defaults may be on the horizon, which could lead to a decline in asset prices.

If state governments reinstate shutdowns and federal stimulus remains stalled, economic strife could return to near March–April levels. That may force US banks to bolster loan loss provisions once again, which will be reflected in Q4 2020 earnings that fall short of Q3’s cautiously optimistic numbers.

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