For months, banks have been warning about reporting a surge in loan loss reserves on their balance sheets when new accounting rules go into effect in January.
Increasingly, investors are wondering what will happen beyond 2020—and aren’t getting much clarity. Some banks say it’s unknown, some believe it could be a positive change long-term, and one rating agency warns the new rules could compound a decline in bank lending during an economic slump.
In investors’ views, the biggest questions surround “day two”—the days, quarters, and years beyond the initial shock of the most significant change to bank accounting in decades. The current expected credit losses (CECL) standard forces banks to forecast the losses they expect on failing loans and book losses before a customer misses a payment. If banks have to count losses up front, will they be less likely to lend to customers with shaky credit? If the economy goes south, will banks tighten lending, in general?
These questions get to the heart of how investors do their jobs, said Scott Siefers, principal at Sandler O’Neill & Partners L.P.
“What will we need to do to our earnings expectations as a result of CECL?” Siefers said.
2021 and Beyond
The accounting change is just that—an accounting change. It doesn’t fundamentally affect the economics of lending. The Financial Accounting Standards Board, the authors of the new standard, maintain that a good loan will be a good loan under the new rules and a bad loan will be a bad loan. The post-financial crisis standard instead changes the timing of when a bank has to recognize losses and set aside corresponding loss reserves.
But when a bank has to shore up its reserves to cover losses on failing loans, it affects the levels of capital it must hold. Changes to capital levels, in turn, can affect business decisions. Analysts peppered bank executives during third-quarter earnings calls about the long-term consequences of the accounting shift.
“What’s the ultimate impact?” one analyst asked executives of People’s United Financial, Inc., a bank headquartered in Bridgeport, Conn.
“We will not operate our bank any differently or think about credit any differently” than now, CFO David Rosato said on the Oct. 17 call.
But analysts are digging for clearer answers. Goldman Sachs & Co. wrote in a Sept. 24 research note that the accounting change could cause “significant” volatility in earnings, particularly if the economy deteriorates.
“This would have the effect of depleting bank capital ratios just as the industry heads into a recession versus being able to gradually build capital and absorb losses as the economy weakens,” the investment bank wrote.
In a note a year earlier, Goldman Sachs said its concerns resolved around the long-term effect it could have on lending economics.
“While accounting shouldn’t drive economic decisions, regulatory capital does, and the way that CECL influences GAAP results will ultimately drive capital allocation,” it wrote.
Fitch Ratings Inc. raised similar concerns in October, publishing a report saying the accounting standard could lead to lower capital ratios. In addition, if a bank has to book losses up front, its profits will likely go down.
“We’re just not sure how that affects the willingness or ability of lenders to extend credit in a recessionary environment,” said Fitch associate director Michael Shepherd.
Quarter to quarter
At least one of the longer-term questions about the new rules is coming into focus.
The immediate day-two effect—how bank loan loss reserves could change from quarter to quarter, at least in the first year—is expected to be minimal compared to the first time a bank adopts the new accounting change.
That means that if a bank on the first quarter of adopting the new rules has to beef up its loan loss reserves by 30%, that unless the economy tanks, it is unlikely the bank will have to make a similar adjustment for the second quarter.
Regions Financial Corp., which expects to have to boost its reserves by as much as 66%—one of the biggest changes among U.S. regional banks—told investors on Oct. 21 that they shouldn’t expect similar jumps from quarter to quarter.
“I would not say that day two would be anything remotely close to day one,” CFO David Turner said. “Day one just kind of level sets.”
The president of Live Oak Bancshares Inc., a small business lender in Wilmington, N.C., told investors on Oct. 24 that as the bank gears up for 2020, it believes the new accounting rules could reduce some of the volatility the bank sees in its quarter-to-quarter provisioning for loan losses.
“So I’ll go on record with the first positive statement about the new accounting methodology,” Live Oak President Huntley Garriott said.
Fear of the unknown
Published by FASB in 2016, the credit losses standard is considered the accounting standard-setter’s chief response to the 2008 financial crisis. FASB says the new rules, which go into effect for large banks in 2020, will give investors and analysts clearer signals and earlier warnings about deteriorating credit quality as opposed to current accounting, which allows banks to book losses only after they happen.
But the rules have been unpopular with banks from the start. After almost a decade of debate, large banks say they are ready to to start following the new rules in 2020, but it appears that many are holding their noses.
“I think in periods of stress in a deep recession, I continue to be worried that CECL will make it more difficult for the banking industry to lend when you have to record lifetime expected losses before you get to record any of the related revenue,” Capital One CFO Scott Blackley said on an Oct. 24 earnings call.
“And so, I’m anxious about that,” he said.