Oh the liquidity! On December 20 the Financial Accounting Standards Board set forth a proposal to require banks to hold more reserves for loans that may go sour in the future. This is certain to get pushback from banks, which are already under pressure from a variety of regulations, most notably coming Basel III rules.
FASB said in a news release that the aim of the proposal is to improve financial reporting “about expected credit losses on loans and other financial assets held by banks, financial institutions, and other public and private organizations.” This could mean banks will have to increase their loan-loss reserves by 50 percent. It could also create a further disincentive to lend.
“The global financial crisis highlighted the need for improvements in the accounting for credit losses on loans and other debt instruments held as investments,” FASB Chairman Leslie F. Seidman said in a statement. “The FASB’s proposed model would require more timely recognition of expected credit losses and more transparent information about the reasons for any changes in those estimates.”
Currently FASB requires banks to follow an “incurred loss” model, which means losses aren’t recorded until it is likely that a loss event has occurred. But because many felt that this model allowed too high a threshold to recognize a credit loss, banks now should follow a “current expected credit loss” model. Under this model, banks would have to immediately estimate the amount of potential losses they might incur on loans, or bonds, and set aside money to cover them.
The problem that many banks might have is that they already are setting up to hold more liquidity to adhere to Basel III requirements, specifically, the liquidity coverage ratio (LCR). The LCR, set to take effect in 2015, requires banks to hold 30 days-worth of high-quality liquid assets that are available for sale, and conversion to cash, in order to maintain solvency for 30 days in the event of a crisis.
Another problem, on a regulatory harmony level, is that the FASB’s latest proposal further separates itself from the International Accounting Standards Board. The FASB and the IASB have been working on converging accounting standards for almost 10 years but have been struggling to unite those standards. Both agree on an expected loss model, however, the difference is the IASB plans to limit estimates for performing loans to 12 months, while the FASB would not limit the time period. Thus, the possibility of convergence becomes even more remote.
Bob Davis, executive vice president of the American Bankers Association, responding the FASB proposal, said requiring banks to extend some estimates of losses “so far into the future” might mean that “reliability will likely be called into question. “
The FASB said it will take and consider comments it receives on the proposal. Comments are due April 30, 2013. Click here to read the full text of the proposal.