Written By: Libby Bierman
A popular meme on social media these days incorporates “Keep Calm and Carry On,” a slogan that originally appeared on a British government World War II-era poster. This catchphrase is also good advice for bankers feeling panicky about proposed changes to the way they account for credit losses. Shareholders of banks, too, should resist jumping to conclusions about what the changes will or won’t mean for earnings.
The move by the Financial Accounting Standards Board (FASB) to an expected credit loss model from an incurred-loss model hasn’t even been finalized, but bankers may be under the impression that they must overhaul their calculation of the allowance for loan and lease losses (ALLL) and boost their reserves significantly. The allowance for loan and lease losses is one of the most significant estimates on a bank’s financial statements, and while it resides on the balance sheet, provisions for it (additions to or subtractions from) flow through the income statement. Other players in the industry, especially vendors standing to gain from a certain type of panic, seem to encourage this anxiety about the FASB’s plans by the way they are hawking their wares.
In fact, I suppose it would actually be in our company’s interest for bankers to panic (given that Abrigo has software that helps banks calculate the allowance). Yet, I still say banks should not rush to make wholesale changes to their existing methodologies. In fact, the FASB has been discussing this change since 2012, and we recently learned that the FASB decided to extend the effective dates by another year. This means even more time for implementing changes and even less reason to panic.
What financial institutions can do now is take measured steps to examine their current calculation processes and to communicate with their boards so that institutional panic doesn’t snowball.
Why are banks worried?
Bankers’ anxiety about what’s known as the Current Expected Credit Loss model, or CECL, is not surprising. Much of the banking industry discussion related to CECL is tied to expectations for a massive impact on reserves. Comptroller of the Currency Thomas Curry himself has said the OCC suspects allowances will increase by an average 30 to 50 percent with the shift, and some industry groups have predicted even larger jumps. Abrigo’ own surveys have found that the percentage of bankers expecting a 10 to 50 percent increase has steadily risen over the past three years. This is interesting research given that I personally can make no such prediction based on my reading of the specific original guidance from FASB.
The language of the proposal is unclear; reserve levels may or may not rise. In fact, the language and structure of the FASB proposal is confusing on several fronts. For example, although there are vague references made to calculating loan losses over the life of loans, there is insufficient detail on how the current methodology would change. And despite several allusions to migration analysis (the need to use a data library of loan loss information to calculate reserves), which could have immense implications, it’s unclear whether this will even be necessary for most banks. There are more than 6,000 banks in the U.S., and most of these institutions have fewer than 500 employees and less than $1 billion in assets. They are essentially small businesses that happen to be operating in a highly regulated, highly stressful environment; the lack of clarity in the accounting standards update is undoubtedly leading to further confusion and anxiety. Finally, some technology vendors are playing up the fear of many bank executives that they’ll fall behind competitors or face regulatory consequences. I understand the need to hit sales goals, but vendors should help their bank customers, not just give them one more thing to worry about. I imagine many bankers have far more important things in their lives than a yet-to-be resolved calculation that is unlikely to cause bankers to make immediate, sweeping changes.
What’s a bank to do?
There’s an important distinction between fear and preparedness. After all, the British slogan wasn’t “Keep Calm and Forget about It.” I am not advocating that bankers sit back and assume their allowance calculation and levels will be just fine the way they are. The quality of a financial institution’s ALLL methodology will definitely play a role in how prepared it is for changes under CECL.
Banks should set reserve rates based upon reasonable anticipation of losses. There is not a one-size-fits-all remedy to calculating a reserve. To a certain degree, there may be an advantage to ambiguous guidance, as banks won’t be forced into modeling their losses based upon methodologies that may not be appropriate for them. For this reason, one takeaway would be for banks to get good training in calculating their reserves and in documenting those calculations.
Based on what we know now about the new model, banks will likely have to develop and justify their expectations for loss rates, especially those differing from historical loss rates. This is actually a good outcome- who could argue that better calculating a key metric important to capital and profitability is anything but terrific for our system? As a result, we think it is likely that banks will need more data for their calculations; institutions can prepare now by strengthening their processes for collecting, managing and storing data. Some banks may choose more sophisticated technologies for this; others may stick with spreadsheets.
If financial institutions focus on the four C’s of credit, things will be just fine. If they are lending to a business and the business pays its bills, has good cash flow, has some collateral to back up the cash flow, and the business makes sense, there’s probably not going to be a material loss on that loan. Over time, the reserve rate will reflect this. In this way, the reserve rate is a result, not a cause. Making good loans is the key to banking and losses are probably going to be pretty low if banks do that.
Finally, bank leadership should be talking to their boards and to their investors. Educate them about current processes for mitigating risk and plans for mitigating risk in the future. It is doubtful that these new standards will collapse banks, which is in nobody’s interest. With some good planning and advice, institutions will be just fine.