Banking regulators are trying to take the sting out of a new accounting standard that will have a big effect on the regulatory capital requirements that financial institutions must follow.
The Federal Reserve, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency have issued a joint proposal to revise their rules in response to the new method for recognizing credit losses under Accounting Standard Update No. 2016-13. The new accounting, which takes effect in 2020, will require banks to take a more forward-looking approach in recognizing credit losses, bringing loss recognition onto the books sooner than under current rules.
The transition to the new accounting is generally expected to create a spike in the regulatory capital requirements banks must meet to demonstrate solvency under banking rules. Accounting experts have said banks are having a hard time determining exactly how they will comply with the new the “current expected credit loss” model, or CECL model, required by the Financial Accounting Standards Board, in part out of concern for what will happen to their regulatory capital requirements. The counterpart standard under International Financial Reporting Standards took effect at the beginning of 2018, which has stoked greater activity in the United States to resolve accounting questions.
The banking regulators are proposing to revise their regulatory capital rules to identify which credit loss allowances under the new accounting are eligible for inclusion in regulatory capital, and to give banking organizations an option to phase in the day-one hit to capital requirements over three years upon adopting the new accounting. The proposal also would revise certain regulatory disclosure requirement to reflect the changes in GAAP under the new credit loss model.
The proposal also contains amendments to the agencies’ stress testing regulations so that the new accounting would not hit stress testing until the 2020 testing cycle. And the agencies are proposing conforming amendments to various regulations that make reference to credit loss allowances. The proposal will be open for comment for 60 days.
The CECL model required under GAAP beginning in 2020 replaces an “incurred loss” approach that has been in place for many years. Under the incurred loss approach, banks do not recognize losses until they occur, giving investors little advance notice when a particular tranche of instruments is performing poorly and may fail. That stinging reality played out in the aftermath of the financial crisis, which is what prompted the FASB to rewrite the rules.
The CECL model requires financial institutions to estimate the losses that might be incurred on a particular instrument at its inception and book an allowance for loss at the very beginning, even when the instrument is fully performing. The new rules do not prescribe an exact method for banks to follow in arriving at such estimates, leaving them to determine for themselves how they will comply with the new accounting.