Despite years of domestic and international controversy, the U.S. is poised to replace the existing incurred loss accounting method for calculating the allowance for loan losses with CECL, the “current expected credit loss” method. The current accounting standard has been in effect for the past 40 years, and CECL, set for adoption in 2020, constitutes a dramatic departure in how loan losses are estimated by the banking industry. While the accounting debate is thus over, an equally important debate about bank capital is now commencing.
First, some brief background. U.S. GAAP currently requires the loan loss allowance be based on a so-called “incurred loss” model; under this method, an allowance for loan losses, or reserve, is provided when a bank estimates that a loss in its loan portfolio has already been incurred. Under this model, a bank must have reason to believe that a loss is probable of having been incurred, and the bank must be able to reasonably estimate the amount of the loss. In sharp contrast, under the new CECL model, banks will be required to estimate the losses that are expected to occur over the entire life of the loan. That is, a reserve must be provided if a loss can be expected to occur in the current loan portfolio at any time in the future. From a practical perspective, calculating the allowance under CECL will be determined in part by banks’ projected estimates of future economic conditions, and how those future conditions will influence the loan portfolio.
Furthermore, although CECL will require banks to provide for future losses expected to arise on loans immediately upon being made, CECL will not permit banks to record the future interest income from those loans until that interest is actually earned in future periods. This mismatch of the timing of recognition revenues and expenses will also result in a mismatch for regulatory capital purposes. Indeed, the U.S. banking agencies have acknowledged that implementation of CECL in 2020 will require a downward adjustment to bank regulatory capital levels (CET1).1 This is because the regulatory capital framework is calibrated under the incurred loss model. But because the CECL provisions represent a reserve for future, not just incurred, credit losses, they essentially represent additional loss absorbency capacity for banks. Therefore, requiring banks to hold capital against CECL accounting losses without a corresponding recalibration downward of the regulatory capital minimums or by allowing a credit against CET1 for the additional loss absorbency on banks’ balance sheets from the CECL provisions, would be inappropriate.
CECL also will provide a strong incentive for banks to reduce lending to riskier customers such as households with less than perfect credit histories; and because borrower risk goes up in a downturn, that disincentive will intensify in a recession, encouraging banks to pull back from lending, potentially amplifying economic weakness. CECL also may result in other significant and adverse impacts involving changes to the pricing, terms and availability of longer-dated credit products (e.g. residential mortgage loans) and increased liquidity risk for companies outside the banking sector as a result of obtaining loans with a shorter tenor (i.e., lower durability of funding and increased spread and refinancing risk for banks’ clients). Furthermore requiring banks to hold higher capital based solely on an accounting change, without any change in economic circumstances, would also fundamentally change the relationship between accounting provisions and regulatory capital, and allow accounting provisions to drive credit allocation decisions by the banks and for the economy.
In short, the regulatory capital framework needs to be changed to treat CECL provisions as additional loss absorbency on banks’ balance sheets so that no additional capital layer is necessary.
1See, e.g., Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, National Credit Union Administration and Office of the Comptroller of the Currency, Frequently Asked Questions on the New Accounting Standards on Financial Instruments — Financial Instruments –Credit Losses (Dec. 19,2016) at 15, question 18, available at https://www.federalreserve.gov/bankinforeg/srletters/sr1619a1.pdf.
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