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Accounting & Disclosure

Treasury May Feel Sting from New Accounting Rule

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March 29, 2018

FASB’s “CECL” could limit liquidity when corporates most need it

Fri Reg and Accting - Law BooksMany corporate treasury executives may be happily unaware of a new accounting rule affecting banks’ loan-loss reserves that takes effect in two years. But it’s time to bone up, because both investment-grade and non-investment-grade corporate borrowers may feel the impact, especially if the economy swoons.

The Financial Accounting Standards Board’s Current Expected Credit Losses (CECL) accounting standard update introduces a new model for the recognition and measurement of credit losses for loans and debt securities. It goes into effect Dec. 14, 2019, for public companies filing with the Securities and Exchange Commission, and aims to provide more timely information about the health of banks’ credit portfolios.

Financial statement users have mostly applauded the new accounting requirements, and the transparency could also be useful to corporate borrowers, which are becoming increasingly selective about banking relationships.

One downside to the new rule: it could impact the availability and pricing of corporate credit. Treasurers may want to discuss the issue with banks sooner rather than later to avoid surprises, since lenders are expected to start adapting loan portfolios to the change well before the rule becomes effective.

FASB’s new accounting standard dramatically changes how banks account for expected losses. Today’s “incurred loss model” recognizes losses when they reach a probable threshold, and only in the period when that occurs. Under CECL, banks must develop models to calculate the expected credit losses over the life of their loans and reflect those lifetime estimates in their reserves.

Longer-term assets and those with lower credit quality are impacted more by economic swings, making them more volatile and requiring greater reserves under CECL. Michael Gullette, vice president, accounting and financial management at the American Bankers Association (ABA), says banks will need to price that use of capital into their products. Competitive pressure may delay price adjustments, but the first banks to “blink” will likely cause others to follow quickly, and borrowers may see a sudden but permanent increase in loan costs.

“A downturn [before CECL becomes effective] could increase that risk,” Mr. Gullette said.

He said banks have been unwilling to state publicly the difficult decision they face: whether to hold higher reserves now to reduce the need to ramp up when the economy sours; or to proceed with a smaller reserve allowance and face a potentially debilitating hit to their capital later. The first option reduces a bank’s lending competitiveness in the foreseeable future, while the second could significantly reduce its ability to lend during a downturn, when liquidity is needed most.

Amplifying that risk, said the head of risk research at a super-regional bank who requested anonymity, is that the economic forecasts banks will integrate into their loan-loss models simply aren’t very accurate from a timing perspective.

“Where macro models often struggle is they miss the exit ramp on the deterioration of the economy—they’re not built to predict that economic turn—so it takes a couple of quarters before the model understands the new environment we’ve shifted into,” he said.

That could exacerbate a bank’s need to increase reserves, amplifying the hit on capital and the reduction in lending.

“And the same thing happens when the recession ends,” the banker said, “There may be a couple of quarters when reserves are elevated even though the real world is improving, making funding and bank lending less available to industry.”

The ABA said in its comment letter on the proposal that loans historically have performed well over relatively long periods, followed by short periods of acutely bad performance. That cyclicality results in historical loss averages that do not accurately represent the losses within bank portfolios at a specific point in time, which instead are likely to be much greater or less than the average.

“Long-term loss expectations within the [life of loan] models would add to volatility in times of systemic distress,” the 2013 ABA letter says. “Once the long-term expectations change, the increase (as it pertains to longer periods) would have a compounded impact, increasing the procyclical nature of the industry.”

Has the ABA’s view shifted at all?

“The pricing, competition and volatility issues are all linked and our beliefs haven’t changed,” Mr. Gullette said. “In fact, based on investment analyst sentiment and preliminary bank work as they prepare for CECL, our positions on these issues are stronger than ever.”

The Risk Management Association’s comment letter addressing CECL’s impact is even more blunt and may be especially relevant in the current environment, when many companies are highly leveraged and face significant risk should rates continue to raise and credit becomes less accessible or more expensive.

“Entering into an economic downturn (as perhaps anticipated in a stress test) will require banks to post heretofore unseen amounts of expected loss allowance even before the severity of the downturn is known,” this 2013 letter says. “Many more banks may fail under this methodology even when economic downturns turn out to be shallow, and the cost of credit to the [borrower] could rise to unacceptable levels, resulting in unintended systemic risk.”

Mr. Gullette said that lower credit quality corporate borrowers tend to struggle to obtain credit during recessions and that CECL could exacerbate their difficulties. He added that investment-grade corporates, which typically had ready access to credit during recessions, may be unpleasantly surprised by the sudden adjustments CECL prompts their banks to make.

“It could be worse for higher quality borrowers, as the lifetime loss aspect will make the ‘day one hit’ worse. Banks will take longer to make up for that initial capital hit,” Mr. Gullette said. “Since CECL is more punitive, banks have almost no incentive to issue loans in the middle of a bad economy unless they have compelling evidence the economy has turned.”

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