By Soyoung Ho
The CARES Act gave big banks the option to delay the adoption of the U.S. accounting standard-setter’s new credit loss rules until the end of the COVID-19 national emergency or December 31, 2020, whichever comes first. But Haresh Sapra, an accounting professor with the University of Chicago Booth School of Business, said while banks have welcomed the decision to delay so-called current expected credit loss (CECL) accounting rule, the legislative effort may have been misguided.
The CARES Act was enacted on March 27 in an effort to avert a complete meltdown of the economy as a result of stay-at-home orders authorities implemented to slow the spread of COVID-19, the disease caused by a novel coronavirus. CARES Act is short for the Coronavirus Aid, Relief and Economic Security Act.
“There have been arguments that due to the uncertainty of the future economic forecast brought about by the COVID 19 virus, banks may face higher-than-anticipated increases in credit loss allowances,” Sapra wrote in a new opinion piece appearing in the Chicago Booth Review on April 14. “But my research shows that the role of expected loss models such as CECL is to reveal timely information about credit losses so that a bank’s stakeholders are more nimble in making informed and sound decisions. Ignoring such information would not discipline risk-taking but could potentially exacerbate risk-taking.” Sapra was referring to a recent academic paper he wrote about CECL and banking regulation.
The American Bankers Association (ABA) applauded the delay in the $2.2 trillion stimulus package. CECL has always been unpopular among banks and other lenders even while the accounting board—the FASB—was writing the rule because it requires them to make earlier recognition of their losses. They had complained that it will be too complex and costly to apply.
Banks prefer the old incurred loss model since they can write down losses after borrowers have essentially defaulted on their payments, and in the past few years have lobbied the board to delay the effective date.
Many investment analysts support CECL, which is considered the FASB’s most important response to the 2008 financial crisis. Regulators and investors complained that the delayed recognition of losses made banks’ balance sheets appear healthy even when the mortgage market was collapsing in 2006 and 2007. Nonetheless, after intense lobbying to delay the effective date, the FASB last year granted only smaller banks more time to implement CECL from 2021 to 2023. Large financial institutions that are regulated by the SEC have already begun applying the rule this year.
Even well before the new coronavirus outbreak, banks have argued that CECL will have a procyclical effect because it requires businesses to look to the future, make reasonable and supportable estimates, and calculate potential losses on loans and certain securities as soon as they issue them and set aside corresponding loss reserves. Banks claimed that they would have to raise loan loss allowances during economic downturns, and this in turn would make banks curb the amount of money they can lend when customers need it most. This could mean more volatile levels of regulatory capital and an increased level of capital at all times. When banks have to raise capital levels, it means they have less money available to lend to customers and less money to invest, and they had asked for a delay.
However, in response to the pandemic, banking regulators on March 31 issued an interim final rule to allow banks that adopt CECL to reduce the impact on regulatory capital for two years. Banks already have a three-year transition period, which means banks get up to a five-year relief. Further, the Federal Reserve on April 1 announced temporary exemptions of certain investments from a key leverage calculation. But only large banks that do not postpone adoption of CECL will get the Fed’s relief. Those that delay implementation do not.
This basically means that loan “losses would not be used to write down capital,” Sapra further explained in an April 14 interview. “In a way, they are getting a break from the calculated capital… lending would not be affected by the losses essentially.”
“I think it’s a very dangerous idea to delay CECL because, in my mind, this is precisely the time where we should be monitoring the risks,” Sapra added. “They are basically making loans that are very risky because the government is giving them money to lend to almost everyone in the economy. And in that kind of environment, it’s extremely important that you monitor your risks and provision for losses because if you don’t, you are not going to be disciplined in your risk-taking.”
Sapra acknowledged that it is not easy to implement CECL, but he pointed out that large banks have been preparing for a few years already since the FASB adopted CECL in June 2016.
“It’s a bit silly that at this stage to say, ‘oh, you know, we should be lending to almost everyone in the economy,’ at the same time say, ‘don’t worry about, you know, provisioning for losses,’” he said. This means that a year or two from now, banks will be writing off the loans all at the same time.
“That’s a toxic combination,” Sapra said. “So, the idea of implementing [CECL] but at the same time getting capital relief, I think, is a good compromise because the idea is that, of course, you should be monitoring your losses but at the same time these losses will not be used to write down your capital, you should anchor it to lend. But at the same time monitor their risks until the economy gets back to normal.”
He explained that Congress may have included the CECL delay provision because banks are worried about their bottom line. In a very low interest-rate environment, banks are lending to risky borrowers, and they will be potentially showing their losses on their financial statements. “They just worry about their performance,” he said. “Anything they can do to avoid writing these losses; that’s why the pushback.”
In the meantime, credit rating agency Fitch Ratings, Inc. on April 13 said it expects the adoption of CECL to be credit neutral upon implementation, “with a delay only postponing the longer-term credit loss impact from the pandemic-induced economic shock.”
Fitch said it expects the majority of banks and other companies to proceed with CECL adoption for the first quarter of 2020.
This article originally appeared in the April 15, 2020 edition of Accounting & Compliance Alert, available on Checkpoint.
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