How an Arcane Accounting Rule Will Help You Gauge Bank Safety

Q-and-A on a rule that requires banks to estimate future loan defaults rather than disclose them afterward to help better gauge credit risk at companies from JPMorgan to Citigroup.
By Valerie Young ,

Have you been wary of investing in banks because it's tough to figure out where the risk is, especially when it comes to potential loan defaults?

A new rule from the Financial Accounting Standards Board, the government-designated organization that sets financial-statement rules for publicly traded companies, should make potential losses easier to see.

Known as the Current Expected Credit Loss, or CECL, model, the standard announced in June will require lenders to recognize potential losses over the life of a loan in the quarter in which it's made. Effective in 2020 for companies registered with the Securities and Exchange Commission, the requirement may initially push up operating costs as companies develop systems to comply with it.

"The accounting rules that will be implemented do not change the ultimate loss that a bank will incur -- it just changes the timing," Hal Schroeder, an accounting board member, said in a phone interview. "That may mean that some reserves go up and some reserves go down, depending on where we are in economic cycles."

Current regulations require banks to record losses on loans only when they are incurred or become probable. The shift "marks the biggest change in the history of bank accounting and has the very real potential to affect how banks do business," Rob Nichols, American Bankers Association president, said in a statement.

While companies like Wells Fargo (WFC) - Get Report, Bank of America (BAC) - Get Report, andJPMorgan Chase (JPM) - Get Reportwillhave to adjust their allowance for credit losses to comply with the new standard, businesses that record contractual cash flows for receivables, net investments, leases, or any financial assets at cost will be affected, too.

EXCLUSIVE LOOK INSIDE: Wells Fargo is a holding in Jim Cramer's Action Alerts PLUS charitable trust. Want to be alerted before he buys or sells the stock?Learn more now.

As with the current rule, after the original loss provision is posted, any subsequent increases will be recorded as expenses and could reduce banks' capital.

"It's a better starting point," Schroeder said. "The accounting will now be aligned with the economics of underwriting or the economics of lending. When loans are originated, that's when you are setting money aside for your expected loss."

Following is a look at some of the most common questions about the change and what it means for investors.

Q: Why the change?

A: In the four years leading up to the 2008 financial crisis, Schroeder said, loans by U.S. banks increased 44% while reserves dropped 10%, leading to a "misalignment between additional credit risk" reported by companies and their market valuations.

Investors and other "financial-statement users were making estimates of expected credit losses using forward-looking information and devaluing financial institutions before accounting losses were recognized," the board wrote.

"The financial crisis revealed a distinct flaw in the incurred-loss model," Thomas Curry, U.S. Comptroller of the Currency, said at a 2013 banking conference. "By requiring banks to wait for an 'incurred' loss event to recognize the resulting impairment, the model precludes banks from taking appropriate provisions for emerging risks that the bank can reasonably anticipate to occur. The result too often has been the need for banks to make large loan loss provisions in the midst of a credit downturn, often when earnings and lending capacity are already stressed."

Q: Will bank reserves go up or down?

A: That depends on several factors including the bank's mix of loans, whether credit is expanding or contracting and how conservatively banks have applied existing rules, Schroeder explained.

Michael Gullette, vice president of accounting and financial management at the American Bankers Association, said banks with more longer-term loans in their portfolios may see a bigger difference in recorded credit losses under the two systems.

"You would tend to think that with banks that have more of their loans that mature way out in the future, there would be a bigger impact," Gullette said in a phone interview. "Residential mortgages are longer-term in nature and the losses come over a five- or six-year time frame as opposed to most commercial loans that are kind of one- to two-year a lot of times."

While the new standard won't go into effect for another four years, BMO Capital Markets analyst Lana Chan said it will likely be a key topic on the second-quarter earnings calls, which begin this week.

"We expect both an initial bump in loan-loss reserves needed for the CECL framework and increased operating expenses for more complex loan-loss modelling demanded by CECL both in terms of technology and personnel," Chan wrote in a note. "We believe the regional banks with the lowest loan-loss reserve ratios will likely need to climb the most."

For the first quarter of this year, Bank of America recorded an allowance for credit losses of $12.7 billion on $901 billion in loans, Wells Fargo noted $12.7 billion on $974.3 billion in loans, and JPMorgan posted a $15 billion allowance on $847.3 billion in loans. Their allowance for losses represents from 1.34% to 1.4% of total outstanding loans.

Q: How will the banks be affected?

A: Banks will have to base loss estimates on historical experience and current economic conditions, while forecasting trends like unemployment and interest rates.

"The important thing is what their forecast of the future is," Gullette said. "Going forward, because it's a long-term forecast, small changes in assumptions could have a pretty large impact on your provisions."

Bigger banks may be less affected because some processes may already be in place to address the new requirements, while smaller banks may have more work to do, Gullette said.

"The process could introduce volatility that could also be a cost of capital," he said. "When you are changing the potential size of capital for banks, that makes it more expensive to do business, but you're also changing the timing of when those expenses occur from the back to the front. That's a huge change."

Some of the operational changes needed will include developing credit-risk models, forecasting methods, and redesigning control mechanisms to ensure the use of appropriate data, auditing firm Deloitte & Touche wrote.

Q: What else can investors look for?

A: Currently, banks are required to disclose "credit-quality indicators" for each class of loans, but they now will be required to submit "vintage" disclosures.

Those will essentially provide investors a roll-forward loss assessment based on loan class and year of origination that's updated each quarter. Banks will also report originations by loan class.

"You will be able to assess how that original estimate changes over time," Schroeder said. "You'll be able to assess how good is management at one bank versus another in terms of estimating their expected loss and how does that estimate change over time."

Loading ...