U.S. Banks Will Turn Last Year’s Fear Into This Year’s Profits

In 2020, banks rushed to build up their stockpiles to cover losses on the assumption that consumers and businesses would default on their loans after government stimulus ran out. U.S. banks had $236.6 billion in total reserves in December, according to the Federal Deposit Insurance Corp., nearly double their level from before the coronavirus upended the economy and sent unemployment up sharply.

Bank executives aren’t so worried anymore. The economy has outperformed banks’ internal forecasts. Vaccine distribution is ramping up. And a $1.9 trillion stimulus package was signed into law last week. Consumers and businesses, they now say, likely have dodged the pandemic’s worst-case financial scenario.

“There are a lot of positive reasons to feel good about the path to recovery,”

Citigroup Inc.

C -1.28%

Chief Financial Officer

Mark Mason

said at the

Credit Suisse

financial-services conference last month. Citigroup, he said, likely will reduce its $27.6 billion pile of reserves in the first quarter, potentially by more than the $1.5 billion the bank freed up in the fourth quarter.

Reserves are meant to cover expected losses on loans. They subtract from a bank’s profit when they are put in place and add to it when they are removed.

Since the start of the year, analysts have lowered their loan-loss projections and lifted the combined 2021 profit forecast for

JPMorgan Chase

JPM -0.50%

& Co.,

Bank of America Corp.

BAC -0.50%

, Citigroup and Wells Fargo & Co., by 10%, or $7 billion, according to FactSet.

Analysts now expect the four banks to earn $77 billion in 2021, up from $61 billion last year.

The improving outlook has lifted bank stocks out of the doldrums. The KBW Nasdaq Bank Index is up 25% for the year to date, while the S&P 500 has risen 5.7%

Still, reserve releases will provide only temporary relief. Revenue is expected to decline slightly at the four biggest U.S. banks in 2021, a result of an expected drop in lending and a slowdown in market activity.

“It’s ink on paper,” JPMorgan Chief Executive

Jamie Dimon

told analysts in January about reserve releases. “We’re cheering that America’s doing better, but we don’t consider that earnings.”

Banks set their loan-loss expectations using broad economic gauges, particularly gross domestic product and unemployment rates. From that starting point, they factor in hundreds of other variables, with some leeway built in for how optimistic or pessimistic executives feel.

Since the start of the pandemic, bank executives have tended toward pessimism when setting aside loan-loss reserves. As a result, their internal models offer a more muted outlook than broader economic forecasts.

The Organization for Economic Cooperation and Development recently said it expects U.S. gross domestic product to grow 6.5% this year, double its December forecast. Economists are projecting unemployment, now down to 6.2%, to keep falling to 5% by December, according to a Wall Street Journal survey.

The improving economic outlook led banks to release some reserves in the fourth quarter. Executives said then they would need more clarity around consumer sentiment and other economic gauges before paring them back further.

As the Credit Suisse conference in late February, executives said the economy’s trajectory is becoming clearer. While they remain cautious, some pointed to a decline in consumer debt and an increase in spending as positive signs for the economy.

“Time will tell if this is an inflection point, but it is reason to be optimistic,” JPMorgan CFO

Jennifer Piepszak

said.

An accounting-rule change last year has further complicated the task of calculating reserves. Banks now have to record expected future losses as soon as a loan is issued, rather than wait for evidence that losses are likely.

Bank executives are still hesitant to explain what normal, nonpandemic reserves would look like under the new rules, said Credit Suisse analyst

Susan Roth Katzke,

who interviewed many of them at the conference last month. Without that information, it is difficult to predict how much they will release in the coming quarters.

“I’m more interested in learning the size of the reserves going forward,” she said.

Write to David Benoit at david.benoit@wsj.com