Amidst concern over an economic slowdown, financial professionals have questioned how a recession could affect an institution’s reserves. Hal Schroeder, a Financial Accounting Standards Board (FASB) board member, led a presentation, “Roadmap to the Future: Fact vs. Fiction (on CECL and Other FASB Standards),” at the 2019 ThinkBIG conference and addressed many CECL questions.
What happens if the economy became extremely volatile, conditions became dynamic, and forecasts became untrustworthy? Could there be a “reversion period zero,” where institutions start with their long-term average out of the gate? Schroeder doesn’t think so.
“Bankers are in the business of pricing for risk,” Schroeder said. “That may be in turbulent times and not great times, but you’re not bankers just in good times – you’re bankers throughout the cycle.” Indeed, bankers make credit decisions each day, underwriting and pricing loans in some capacity, meaning these bankers should have a fairly accurate expectation of losses.
Schroeder is least concerned over small, rural banks in a volatile economy because they interact with them every day. “They’re driving past them, they’re having lunch with some of them, they used them in services – they have a good feel as to where the problems are and where they’re not.” By having a better pulse of the health of their loans by interacting with them on an everyday basis, modeling tools and forecasting is less important. “I think they’ll be able to come up with and make cases for CECL-like estimates. Those are the ones that tend to come up with me and say, “My number’s going to be just fine and here are the reasons why,” he said.
So, what should your financial institution’s reserve levels look like heading into a recession?
Schroeder argues that reserves are less influenced by procyclicality or countercyclicality and more influenced by the strength of underwriting standards. Quoting a speech by Bill McDonough, former President of the Federal Reserve Bank of New York, he said, “Banks don’t make bad loans in bad times, they make bad loans in good times.”
Leading up to the Great Recession, loans increased by 35%; however, loan loss reserves declined by 10%. It’s critical that accounting is aligned with changes in risk.
Procyclicality is not driving the standard, Schroeder explains. “If someone is going to point to the fact that a loan loss reserve will go up in a recession, I fully expect that to happen, and it will happen under CECL,” he said. Schroeder estimates that loan loss reserves would have gone up approximately 29% in the last recession under CECL, significantly less than the 264% actual increase.
“It’s clear that the banks that position reserves early – book reserves before the recession – tend to continue lending in a recession and don’t cut back. It’s those that waited, didn’t deal with the realities of rising risk and loosened underwriting standards that have to cut lending in a recession. If there’s a discussion about procyclical, that’s where the discussion ought to lie,” Schroeder explained.
Among his indicators to determine whether financial institutions are heading towards more difficult times and the impact it will have on allowance? Customer demand. “Customer demand starts to fall in advance of every recession. Look at patterns within your own institution,” Schroeder advises. “You know who your best customers are, you know who your middle group is, and you know who your worst customers are. Just watch the borrowing patterns of those customers alone and that will tell you a lot about where we’re heading in terms of whether or not you’ll need additional reserves.”
About the Author
Kylee Wooten is a content marketing manager at Abrigo.