Fed study minimizes lending, volatility concerns of CECL

Two board members of the Federal Reserve studied how a current expected credit losses approach to recognizing credit losses in financial statements would have affected the period leading up to the financial crisis of 2008. The CECL approach, required by the Financial Accounting Standards Board under Accounting Standards Codification Topic 326, is set to take effect Jan. 1, 2020, for calendar-year public companies, although FASB is considering a delay for smaller reporting companies and other non-public entities.

A large number of banks, including the American Bankers Association (ABA), have called on FASB to delay CECL for all companies, concerned it may have a “procyclical,” detrimental effect on the economy. They believe the increased reserves banks will need to hold to cover for life-of-loan loss estimates under CECL will make it more difficult for borrowers to get loans, especially as the economy heads toward a period of stress. They are predicting volatility both for reserve requirements and for reported income.

Banks have even petitioned Congress to intervene, and they have won the ear of some members, although bills introduced there so far have not gained enough support to move through the legislative process.

The study by Fed board members Bert Loudis and Ben Ranish suggests the concern is not as great as big banks seem to fear. Using data to create a model of how CECL would have affected bank lending from 1998 through 2014, the study says CECL will “modestly affect bank lending in a way that dampens fluctuations.”

During the period before the financial crisis in 2008, for example, had CECL been in effect, banks would have reduced lending leading up to the crisis and increased lending during the recovery. That would have had the effect of “modestly decreasing the volatility of lending growth,” the study concludes.

The findings are consistent with what FASB heard from stakeholders as it worked over several years to develop the new model, says FASB Chairman Russ Golden. “I’m pleased but not surprised by the general conclusions of this objective study of CECL,” he said. The board is committed to continuing its engagement with preparers, auditors, and others, he said, answering questions and providing assistance, all aimed at “helping ensure a smooth, effective implementation of CECL.”

The ABA is not as confident in the newest study. “In the real world, banks will forecast credit losses in light of supervisory expectations that are grounded in stress tests and are subject to auditing standards designed to minimize earnings management,” said Mike Gullette, senior vice president of tax and accounting at the ABA.

Those factors are not captured in this new study authored by Fed board members, he says. Still needed, says Gullette, is “a robust, quantitative impact study of the standard’s potential effect, particularly on lending.”

In the meantime, financial institutions continue their march to compliance with CECL beginning on Jan. 1, 2020, for calendar-year entities. Because the standard shifts banks from reporting losses as they are incurred to projecting lifetime losses and reporting them upfront, experts have generally expected banks to report increases in reserves.

“In the real world, banks will forecast credit losses in light of supervisory expectations that are grounded in stress tests and are subject to auditing standards designed to minimize earnings management.”

Mike Gullette, SVP of Tax and Accounting, American Bankers Association

A recent analysis by Audit Analytics shows only a handful of entities have so far disclosed how they expect to be affected by the standard. JPMorgan said it will increase its credit loss reserves on its $150 billion credit card portfolio by some $4 billion to $6 billion, and Citigroup’s reserve across its portfolio is expected to rise $400 million to $600 million.

Two major organizations disclosed some unexpected effects, however, reporting their reserves will actually decline when they adopt the new accounting. Wells Fargo said its reserves on short-term commercial loans will drop by as much as $1 billion, and its reserve for residential mortgages could fall by $1.5 billion. Synchrony Financial also said it expects the new standard to reduce its regulatory capital.

Larry Smith, senior managing director at FTI Consulting and a former member of FASB, says he wasn’t expecting to see instances where banks would reduce reserves given the change from an incurred loss model to one projecting lifetime losses and recognizing them at the inception of an instrument. “I don’t think there were many board members expecting reserves to go down,” he says.

It’s possible some entities may have reserves that are overstated under current GAAP, says Smith. Perhaps as a result of a conservative approach to satisfy banking regulators, some banks may be recording reserves on “an incurred-plus loss basis,” he says.

It’s also possible, says Smith, a reduced reserve could be rooted in the interplay between accounting rules and banking regulatory requirements with respect to the write-off and eventual recovery of bad loans. CECL will generally accelerate the recording of expected recoveries compared with current GAAP, he says, which would affect reserves.

Yet another factor, says Smith, is how a given financial institution treats loans it expects to roll over, or renew. “Under CECL, you don’t look at future loans or loans that are expected to renew,” he says. “You only look at current loans.”

Jonathan Howard, senior consultation partner at Deloitte, says the standard’s requirement to focus on the contractual life of a loan could lead to smaller reserves for certain types of instruments, such as credit cards or revolving instruments, for example. During consultation with FASB’s Transition Resource Group, accountants were told CECL prohibits companies from establishing allowances on unfunded lines of commitment where the entity has unilateral authority to shut it down. “It wouldn’t surprise me if we saw instances of credit losses declining,” he says.

As entities get deeper into preparing for the new accounting, it’s still difficult to predict systemically what will happen to reserves, says Howard. It will depend on any given entity’s asset mix as well as economic conditions at the time of reporting, he says.