In January 2020, most SEC-filing financial institutions began operating under the new current expected credit loss (CECL) accounting standard. While loss provisions were expected to increase due to the new standard, the onset of the economic impact of the coronavirus pandemic also created new implications for financial institutions’ reserves. Reports from the first quarter revealed a surge in loan-loss provisions at big banks – totaling nearly five times as much as the previous period. Initial second-quarter reports indicate that banks are continuing to bolster their reserves. Is CECL the primary reason for this surge in reserves, or are financial institutions getting ahead of the curve in preparation for the fallout from the coronavirus? Garver Moore and Dave Koch, Managing Directors of Advisory Services at Abrigo, discussed the surge in provisions and the implications the coronavirus has had on financial institutions’ reserves and liquidity on the latest Abrigo “State of the Union” podcast.

“If I were to gather a bunch of bankers around a campfire and put a flashlight under my chin and tell a scary story about an accounting change, this is that scary story,” said Garver Moore, Managing Director of Advisory Services at Abrigo.

CECL, combined with the unprecedented economic fallout from a global pandemic, created a huge headache for forecasting losses. Some economists were predicting 30% unemployment, while others were calling 10% unemployment. Ultimately, no one was certain of the impact the coronavirus would have on the economy by Q1 reports.

“What made March 31 significant was that we were deep enough into something, but not deep enough to really price it,” Moore said of the first-quarter reports. “You saw results that were all over the place, especially as we moved down the size range. Some institutions made minor adjustments, saying ‘we’ll see,’ while others were more proactive about it.” Moore expects a “truing up” to occur moving into the second half of the year and beyond, regardless of the accounting standard financial institutions are using.

The CECL standard requires pricing in the future and uses forward-looking forecasts, allowing data to be responsive as changes occur – which is especially important in uncertain times. The incurred loss model, on the other hand, looks at current and historical factors. Prior to the coronavirus pandemic, the economy was strong and financial institutions were experiencing minimal losses and reporting a low number of problem loans. The current conditions are a prime example as to why the incurred loss model is changing, according to Moore.

Regardless of the accounting model institutions are using, banks and credit unions should be prepared to make changes to qualitative adjustments and consider expectations for credit losses in the near term “Now when institutions calculate their historical factors, they need to basically ignore it because it’s meaningless in the present environment, and then adjust to what you think is the actual answer,” Moore said.

Eventually, economic conditions will stabilize, and suddenly, the historical factor will become pricing in a pandemic. “It’s the same problem, but the opposite side of the problem,” Moore explained. “Larger banks on CECL, if their models are great and they charged through what they provisioned, then they’ll be back to relatively low reserves. If they provision in excess, through maybe a conservatism in their modeling approach, then that will become earnings pretty quickly.”

Looking at initial loan loss provisions, some economists and financial industry experts have drawn parallels between the current economic recession and the Great Recession. While the economic impacts of the coronavirus pandemic may have hit quicker than anyone anticipated, banks are in much better shape than they were in 2008. It’s important to remember that the current economic crisis is not the result of a banking problem and that banks were well-capitalized before the pandemic.

Impacts to liquidity

Currently, financial institutions are awash with liquidity after a record $2 trillion surge in excess deposits reported in Q1. “A lot of banks and credit unions are asking, ‘What do we do with all of this liquidity,’ but remember, just four to six months ago, everybody was looking for liquidity,” Koch said. Much of the money that flowed into banks was driven by government stimulus efforts. Many banks Koch has worked with in recent months have reported that the money deposited from the stimulus, such as Paycheck Protection Program loans or unemployment, has “been sticking.” This poses a potential problem with capital ratios.

“Institutions are sitting on all of this cash, and when it finally starts to get spent, I worry about the overreach of a regulator saying, ‘Well, your capital is under pressure because assets are up,’” said Koch. “We always report on a trailing basis, so the question asked is, ‘what was your capital ratio at the end of last quarter,’ rather than ‘what is your capital ratio today?’”

Moving forward, banks and credit unions will have to think critically about their financial situation. In addition to considering the national economic situation, institutions must also consider their regional market and the bank or credit union’s specialization. “I’d recommend the 80/20 rule,” Moore suggests. “You’ll find the specific credits that will be the primary drivers of future credit loss events, and as those are identified and worked through, you’ll be in a better position to determine your financial picture going forward.” Financial institutions should remain cautious and vigilant when considering the allowance and growth opportunities, and they should be prepared to make adjustments to their models as the economy continues to change.

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