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Bank Regulators Issue Guidance for Credit Loss Standard

Federal banking regulators said banks will change their practices for setting aside loss reserves under the FASB’s new standard for writing down bad loans and securities. The regulators said they believe the implementation of the standard can be modified and scaled down for smaller banks, but they want banks to quickly begin implementing the changes, given their significance.

Federal banking regulators on June 17, 2016, said that banks will change their practices for setting aside loss reserves under the FASB’s Accounting Standards Update (ASU) No. 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.

The FASB published ASU No. 2016-13 on June 16. The standard is the most substantial change in years to the accounting for writing down bad loans, securities, and receivables.

The regulators said they want banks to implement the update to U.S. GAAP in a way “that is both reasonable and practical, taking into consideration the size, complexity, and risk profile of each institution.”

A separate statement for banks with less than $1 billion in assets said, in part, “The agencies expect the new accounting standard will be scalable to institutions of all sizes, and that smaller and less complex institutions will be able to adjust their existing allowance methodologies to meet the new accounting requirements without the use of costly and complex models.”

The regulators said they believe the implementation of the standard can be modified and scaled down for smaller banks, but they want banks to quickly begin implementing the changes, given their significance.

The regulators also said they believe banks can adapt their existing systems for monitoring the performance of outstanding loans and the securities they hold and use them to make the necessary forecasts for estimating loss reserves. They added that they do not plan to set benchmarks that banks will have to use when they determine the level of loss reserves they need because they want to give banks the flexibility to determine how much they need to set aside.

The agencies advised banks to use judgment when determining how much they need to set aside but also said that the decisions will have to be backed up with documentation.

The regulators had given previews of their guidance during a February roundtable with community banks at the FASB and again in April when the accounting board held the first public meeting of the advisory panel it formed for the credit loss standard, the Transition Resource Group. A panel using the same name was formed when the FASB and IASB issued their revenue recognition standards in 2014.

At each session bank regulators and FASB members reassured the bankers who were in attendance that the new standard would be far less disruptive to their practices than they had feared. The statements seemed to ease many of the concerns banks raised.

Banks were also advised that their senior executives and directors should be apprised of the changes.

The amendments to U.S. GAAP become effective in 2020 for public companies. Private companies, not-for-profit organizations, and employee benefit plans have until 2021 to adopt the changes for full-year financial statements, and 2022 for reporting periods less than a year. But the FASB said the changes can be adopted voluntarily as soon as 2019.

The standard is a significant development for bank regulators, given that as the mortgage market began the steep decline that would deteriorate into the 2008 financial crisis, banks were found to have down a poor job building up their capital bases and setting aside loss reserves that would have cushioned the losses they suffered. The subsequent losses caused an usually large number of bank failures and bailouts of an unprecedented to size. The bank regulators were harshly criticized for their failure to spot the trouble sooner.

The amendments to U.S. GAAP will force banks to switch to a so-called expected-loss model that will have them make forecasts of the business climate and other factors and set aside loss reserves much more quickly, instead of the incurred-loss model that has been in place for decades. The bank regulators believe the higher capital bases that will result will limit the risk of bank failures during the next recession or stock market crash.

The accounting changes require businesses and other organization to measure the expected credit losses on financial assets, such as loans, securities, bond insurance, and many receivables, the FASB said. The accounting changes apply to instruments recorded on balance sheets at their historical cost, although there are some limited changes to the accounting for debt instruments classified as available-for-sale. The accounting board added that the write-downs will be based on historical information, current business conditions, and forecasts, and it expects the forecasts to improve the loss estimates on financial assets that are losing value. The board also said the techniques that are employed today to write down loans and other instruments can still be used, although it expects the variables for calculating the losses to change.

The standard’s publication effectively concludes a process begun before the 2008 financial crisis, which gained urgency once the crisis hit. The project was also a joint effort with the IASB in its early years, but by 2012 the boards’ differences about the method for recognizing losses caused them to break off joint discussions and work on their standards separately.

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