How Are Commercial Banks Faring in the Pandemic?

How are banks responding after nine months of the pandemic? In this episode of The Purposeful Banker, we look at two particular areas - provisioning and bad loan sales, in which bank actions seem to tell two very different stories.




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Jim Young: Hi and welcome to The Purposeful Banker, the podcast brought to you by PrecisionLender where we discuss the big topics on the minds of today's best bankers. I'm your host, Jim Young, director of content at PrecisionLender. I'm joined again by Dallas Wells, our EVP of strategy.

Today, we're going to talk about how banks are responding after, well, almost now eight months of the pandemic. And I guess, well, actually almost nine months of the pandemic. And specifically, we're going to look at two particular areas: provisioning and the sale of bad loans, in which at least to the marketer on this podcast feels like bank actions are telling two very different stories.

But as those of you who are faithful listeners know often our podcast is Dallas patiently explaining things to me about how commercial banking works. But Dallas, let's start off with S&P Market Intelligence article. It's titled, Tsunami of Problem Loan Sales Expected in First half of '21, but Discounts Could Be Steep. And first off, I love the use of the word Tsunami in a title. I wanted to use it in a white paper we wrote last year and was overruled and I'm still bitter about it, but that's not neither here nor there. Dallas, first walk us through generally what's being covered in this piece?

Dallas Wells: So, really where this came from is OceanFirst, which is a bank based out of New Jersey, sold, I think, an 80-something-million-dollar portfolio of loans at a pretty steep loss and explained it in their earnings releases as, basically, we grouped everything together that we were concerned about and we just flushed it. Really the way they looked at it is free up head space. There's a lot of, as we've talked about on this podcast a lot, there's a whole lot of things going on. There's a whole lot of risks out there. There's a lot of things for banks to try to deal with. So they just wanted to basically take their lumps early and move on and be able to focus their attention elsewhere strategically and for their management team and everything else.

That wasn't a surprise in the industry that some of these blocks of loans would be coming up for sale. I think the interesting thing was to see where those would actually clear. This particular portfolio has about 75 cents on the dollar. And the article's talking about some analysts, some consultants out there who feel like this is really just the first of many and that there will be a pretty big wave of sales like this that start happening next year, and particularly in the commercial real estate space. And these loans for OceanFirst were hotel-focused loans for the most part, that there could be a lot more like that where banks just try to get rid of them because they don't want to carry the problem assets. And they choose this as a path rather than trying to working those out individually loan by loan. So that's the summary of what the article is talking about and really what the industry is wrestling with right now is, how much of this is there going to be?

Jim Young: Yeah. I do remember too, I guess, some analysts giving OceansFirst some kudos on, "Hey, way to get ahead of the curve on this." That they seem to feel like this is probably smart on their part to sell it off now before there's going to be essentially what they can, I guess, consider to be a big buyer's market in these bad loans.

Dallas Wells: Yeah. What history tells us is, if this is really going to be an ugly credit cycle, that early movers have a distinct advantage. The market reacts better to it. You end up getting a better price for the stuff that you do try to liquidate and recover. And you can just be healthy and opportunistic as everyone else is slowly bleeding through this. So management teams have some interesting challenges here as they have to figure out how to solve some of these, how to react to them.

What it feels like is, do you take this one early blow upfront and just try to package everything together that could potentially be an issue and just get rid of it or do you potentially let it linger on and either it works out and you don't have to sell for 75 cents on the dollar or you end up potentially dying a death by a thousand cuts where these things just linger on and on potentially for years and they act as an anchor on the performance of the bank for a long time yet to come?

So, It's a bit of a fork in the road and they did get some kudos out in the market. The market actually reacted pretty well. They, I believe, reported a net loss for the quarter mostly driven by this loan sale, but the market didn't react too terribly to it and was like, okay. Then at least now we know where we stand with them and they feel things are good and off we go onto business as usual.

Jim Young: Yeah. So that actually segues nicely into our other one because while that seemed to be a case of, hey, smart move to assume the worst on these loans and act quickly on them and then the next article, to me, feels a little bit like maybe banks in some cases assumed something worse than what really happened. So in the first article, we talked about a ton of bad loans and how there's going to be a rush to sell them off. Only getting cents on the dollar. That seems to be, boy, an indication that pandemics have hammered banks and balance sheets are showing pain. But then the next article also from S&P Market Intelligence titled, U.S. banks cut provisioning by more than 80% in Q3. So again, walk us through that one because my first impulse is okay, so maybe things haven't been nearly as bad as we thought they were going to be.

Dallas Wells: Yeah. So this is the flip side of that coin. And first of all, I think most bankers understand this, but I'm always struck by the fact that these words get tossed around and even not all folks who work inside of banks are clear on what the terminology means. So provisions.

Jim Young: You're gently about to say Jim, your question made absolutely no sense and you don't know what you're talking about.

Dallas Wells: No, your question was good but what I want to be cautious of is, Jim keeps saying that word. I want to make sure he knows what it means, talking about provisioning. So a provision, it's an income item or an expense where a bank takes an expense and they make a provision to their loan loss reserves. So think of these reserves as the rainy day funds. So it's where banks set aside money for loans that they expect to go bad or I should say that more clearly, the losses that they expect to realize when some loans go bad.

So in the first and second quarter, banks made massive provisions. In effect, they were beefing up the savings account for what they expected to be some rainy days. And then in the third quarter, those provisions were down by 80 plus percent and we've yet to see the full industry numbers. But the big publicly traded banks that make up the bulk of those have reported. We know that'll be pretty close to right. And in fact there was some, Fifth Third off the top of my head, I'm sure there were some others of note, actually released some of those reserves. They took back some of the rainy day funds that they'd set aside in the first and second quarter.

And so the question is, well, how can we have a tsunami of bad loans and also 80% reduction in provisions? And the short answer to that is that credit losses never show up quite as fast as they are expected to.

Credit losses are slow, painful affairs where a business can limp along for a while, especially when there's things like forbearance programs and stimulus packages from the government, rental forbearance, all kinds of stuff has been out there to make it hard for banks to really understand where the real risk is. You've got some borrowers out there who've been able to limp along for this eight, nine months. Seemed to be doing okay, service the debt as they've been asked to. And then you have to go through a period of some trouble. Before then, the bank decides to try to cure that in some way and eventually go through a workout and eventually realize the loss on that deal.

You're talking about something that even in an environment like this, where markets and the economy closed for a while, actually just close for business. The impact was a little muted or at least deferred. And so banks don't really know exactly what these losses look like yet. They don't know how much of that rainy day fund they're going to need. All they know is that so far the metrics and the actual realized losses don't justify another big provision in the third quarter.

So it doesn't necessarily mean we're done. Doesn't mean that that's the extent of the losses. It's just that that's all we can pragmatically set aside at the moment for what is still a really fuzzy picture for the industry. So both can be true in that there's some uneasiness out there, there are some pockets of problems. But also the industry came into this really healthy and in solid enough shape that when things looked as scary as they did in March, April, May, June, banks were able to just set aside massive amounts of provisions into these reserve accounts and to be pretty well positioned. There's a pretty healthy cushion now between capital and reserves where banks can withstand some pretty significant losses without it showing up on the income statement again.

That's what we'll be watching for over the next couple of quarters is, what are the net charge offs actually look like? How do those reserve accounts stand up? And do banks feel like they need to make additional provisions or are we good? Did they guess right early on and set enough aside to withstand this?

Jim Young: Okay. So we'll see. I'm going to test your ability to politely steer my questions back from dumb marketer question to commercial banker question. I guess I'm wondering though is like obviously banks aren't dying to provision a bunch of money. They'd rather put it somewhere else. So I guess what I'm wondering about is does that cut at all tell us that maybe they overestimated and if they overestimated, could that money have been put to better use somewhere else?

Dallas Wells: Yeah. Just to make it even cloudier than it already was, we also had CECL adjustments happening at the same time where on top of a pandemic arriving at our door, we had some accounting changes. So some of this is just new accounting rules explained some of what happened earlier this year. And some of it is the banks actually being cautious. So could that money had been put to better use? Of course, it can be earnings and it can generate capital, which is a little more flexible. But with the way these reserve accounts work now and with the CECL methodology, we saw it already in third quarter. If things are not as bad as banks expected, those reserves can be released. And instead of an expense item, it's an income item. It goes back to the plus side of the ledger instead of the minus. So they can recoup it. It can eventually show up as capital anyway, and I think especially for the publicly traded banks. The markets, it's hard to remember it, but markets looked really scary for a little while in February and March, down 30 plus percent from their highs and down really quickly.

So it was an opportunity where share prices were already getting just waylaid. So it's like, hey, the stock price looks ugly right now anyway. The market expects some ugly results. Let's just go ahead and make this big ugly provision right now while it's easy to explain. And if some of the trickles back into earnings later, than great. It's some upside for tomorrow. We'll take the pain while it's easy to take. I think that was part of what happened is it was a good environment. And again, banks were already healthy. Nobody had capital levels that they were worried about. So it was a healthy place to take that.

The other interesting thing about this is that we've talked about industry level stuff to this point, but this is really like all credit issues, very different bank to bank. And even within our client base here at PrecisionLender at Q2, we've got some who are like, basically, "What pandemic? We've barely missed a beat." Our borrowers are carrying on like it's, for the most part, business as usual. The only thing that was different for us was that we started working from home for a little while and PPP was a butt-kicking. Otherwise, all normal.

And then we've got some others who are, it feels like shades of 2009, 2010 with some of them where they're like, basically, stop the presses on all new business because we've got some really ugly credit problems to work through. And all of the things that go along with that, cutting of expenses, changeover of management teams. Some painful, ugly stuff. So credit issues are almost always localized in some way. Localized geographically and also localized by industry. And that's once again the case this time.

Like we talked about earlier, OceanFirst had pretty big exposure to hotel loans and they paid a pretty hefty price for it. They took an aggressive action to realize that loss and move on, but there's lots of others that face the same sort of exposure to the travel industry or to hotels or to restaurants or to a local economy that is very dependent on tourism. There's some markets that are just way worse off than others.

So that's what the markets are trying to work their way through. What management teams are trying to work their way through is, what's it look like, not just for the industry, not just the global economy, but also locally and to our institution and our portfolio specifically? That's the only thing that's gotten clear is where the exposure is. What industries are really affected? We've gotten clearer on that. We still don't know the depth or the length of what this is going to be and how ugly that exposure could really get. But we know where to look now.

Jim Young: Got you. All right. So I think you kind of answered my last question on here, which was going to be essentially, how do you, with my sort of simplistic view of the first one being sort of a, Hey banks are struggling, they got to sell these bad loans. And the second one being, Hey, banks don't need as much provisioning now as they'd had before. So things weren't as bad. Is there a way you would... If you had to recap how things have fared so far during the pandemic. But it sounds like you are taking the gutless way of saying it's all very unclear. Is that fair to sum up?

Dallas Wells: Yeah. I think there's a joke in there about a one-handed economist. But I think the other issue that is worth bringing up that is a universal across the board thing that we hear from every bank we talk to. Wherever they are on their individual credit health and wherever they are in that cycle, everyone is struggling with their P&L just because of where interest rates are. So the other side of this pandemic and the economic fallout of it is, rates were already pretty low from a historical standpoint. And now we are near zero and it's going to be that way for a good long while. And that's really painful for banks and their net interest margins.

And so a lot of banks we talked to are what we refer to as budget neutral, meaning they can't add new expense for anything. They either have to stay exactly where they are in the coming years or even cut some expenses just to offset that, just the impact of interest rates. And just to put that in a little context. As I was pulling up these articles you wanted to go through, one of the other headlines on S&P global was 10-year treasury yield surge could prompt fed response. And they have a chart on there that shows what that massive surge looks like. It's the 10-year getting to about 96 basis points. So not even 1% now qualifies as a surge in 10-year rates that the fed might have to actively do something about. That's the major headwind.

I think banks can withstand whatever credit losses come out of this. They're, as we've talked about, an ad nauseum. They are well positioned for this. No one is well positioned for low interest rates because that is literally the lifeblood of a bank P&L is that margin. Whatever your business model looks like, margins are the driving force there. And they are going to suffer. So that's the tricky part that banks will have to figure out how to navigate on top of really struggling to be able to invest in any initiatives to make that happen because budgets are really, really tight and probably again will be for a while. So that's the overarching third theme. And I'll try not to cop out and just say, it depends.

Jim Young: That was good. That was good. I was probably a little bit touchy about you talking down to me about provision earlier in this podcast. All right. Well, that will do it for this week's show. Dallas, thanks again for coming on.

Dallas Wells: You bet. Thanks Jim.

Jim Young: And thanks so much for listening. Now, for our few friendly reminders. You want to listen to more podcasts or check out more of our content, visit the resource page at or head over to our homepage to learn more about the company behind the content. If you like what you've been hearing, make sure to subscribe to the feed in Apple podcast, Google play or Stitcher. We love to get ratings and feedback on any of those platforms. Until next time, this is Jim Young and Dallas Wells. You've been listening to The Purposeful Banker.


About the Author

Jim Young

Jim Young, Director of Content at PrecisionLender, is an award-winning writer with experience in a range of positions in media and marketing, from reporter to website editor to content marketer. Throughout his career Jim has focused on the story – how to find it, how to understand it, and how best to share it with others. At PrecisionLender, he manages the many ways in which the company shares its philosophy on banking and the power of relationships. Jim graduated Phi Beta Kappa from Duke University and holds a masters degree in journalism from Columbia University.

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