The Financial Accounting Standards Board (“FASB”) has mandated a new methodology known as Current expected Credit Loss (“CECL”) to calculate a bank’s Allowance for Loan and Lease Losses (“ALLL”).
Currently, ALLL estimates charges over the next 12 months based on collectability of impaired loans and default probabilities for non-impaired loans. CECL estimates expected losses over the entire life of a loan based on quantitative modeling and management judgment regarding future economic trends.
Originally, all SEC filing financial institutions were to comply with CECL by First Quarter 2020 and all other institutions by First Quarter 2022. However, reporting requirements for all financial institutions other than large, publicly traded entities has been pushed back to First Quarter 2023 due to concerns around the applicability, cost and resource impact of CECL on smaller banks and credit unions. Many bankers believe CECL is flawed and will harm the country’s economy in bad times and weaken credit discipline in good times. However, FASB and the prudential regulators believe CECL will help banks provide capital to the economy in bad times, while rewarding shareholders of well-run banks in good times. This article will discuss how the need for CECL arose, and the basis for these disagreements.
CECL is an outgrowth of the Great Recession. From 2008 – 2010, the US Treasury injected $245 billion of capital into the US banking system through the Troubled Asset Relief Program. As reflected in the following chart, when comparing then existing ALLL levels to charges over the following three years banks were under reserved by approximately $80 in the aggregate during the Great Recession. The goal of CECL is for banks to proactively build ALLL before economic cycles hit while providing bankers the flexibility to reduce ALLL in good times. In theory, this will reduce industry dependence on taxpayer dollars in bad times, and reward investors in the good times.
Timing is the fundamental reasons for the mismatch of reserves to charges shown in the chart to the right. Current methodology estimates losses one year out. Elevated loan losses over a recession may be in place for 2- 3 years. As a result, in a severe recession, credit losses will overwhelm reserves, eat into capital, and in the case of 2008, force government intervention to prevent industry insolvency. CECL attempts to address this issue by looking at losses over the entire life of the portfolio, theoretically resulting in appropriate ALLL to handle all credit-related losses and not impinge on existing capital levels.
CECL addresses a real problem. The challenge is its implementation. Looking at impaired loans is a good way to get a feel for losses one year out, but inadequate to estimate losses for the typical 3 to 4-year average life at most banks. Therefore, FASB is requiring banks to build and maintain appropriate quantitative models reflecting management views of economic conditions over the life of their current portfolio, as well as portfolio specific impacts on various asset classes within the bank’s loan book. The models need to reflect two basic risks: duration (the longer the loan duration, the greater the risk, and the larger the ALLL) and interest rates (the higher the projected interest rates, the lower the value of existing fixed-rate loans, and the higher the ALLL). The complexity of these models requires assimilation of high levels of external credit and economic data, as well as a sophisticated quantitative staff to develop and maintain the models. Additionally, subjective management views of the economy will fundamentally drive ALLL at individual banks. These issues drive banker’s concerns around CECL implementation.
Projected CECL Impact
Although not yet included in GAAP, several prominent southeastern banks have reported probable financial CECL impact on ALLL allowances. Both Regions and Synvous have stated 2020 ALLL reserves will likely increase 40% to 60% due to CECL, BB&T estimates a 30%-50% increase. Major money center banks have noted similar increases. Implementation of CECL will cause a one-time hit to earnings as ALLL reserves increase. Theoretically, these reserves will reverse out into revenue over time as loans are successfully repaid, however, initially Tier I capital will fall, weakening the bank’s relative standing with the regulators, and resulting in longer diluted EPS payback periods in M & A scenarios. Tier II Capital, which adds back ALLL to Common Stock in the calculation of Capital, will be unaffected by CECL.
Although there seems to be consensus CECL may be appropriate for the large, money center banks, regional and community bankers (and credit unions) have the following issues with CECL:
- Model and data related cost and management time;
- Management subjectivity underlying modeling assumptions;
- Less complex nature of most community bank portfolios does not require complex modeling; and
Procyclical nature of CECL provisions may cause less bank lending as we enter recessions due to outsized ALLL provisions reducing banks’ willingness to lend, while potential large ALLL reversals as times improve may increase lending and support asset bubbles in the overall economy.
CECL will have an impact on earnings and capital ratios for publicly traded banks in 2020. That said, CECL is non-cash and well vetted by the investment community, so the earnings impact should not be a surprise. However, it will represent a real burden on smaller banks in terms of time and money, with probable limited upside regarding improved ALLL analytics. As a result, the industry will likely push FASB and the prudential regulators to delay, or cancel, the CECL requirement for non-money center banking institutions.
Michael G. Rediker, CFA is an investment banker with Porter White & Company in Birmingham. He routinely provides M&A and other advisory services to community banks across Alabama. Mike Murphey is a financial analyst who supports Porter White’s Community Banking practice. He has spent forty years in the southeastern US banking industry in various capacities related to commercial lending, including relationship management, underwriting, credit, and portfolio management.