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INSIGHT: Covid-19 Crisis and Banks’ Provisioning Models

May 28, 2020, 8:01 AM

The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) enacted on March 27 gave financial institutions the option to delay a new loan loss provisioning standard, the current expected credit loss (CECL). The main objective of the CARES Act is to provide support to the U.S. economy amid the Covid-19 crisis. But how could a delay in the implementation of a new accounting standard benefit the U.S. economy?

Importantly, loan loss provisioning standards prevailing in the run up to the 2008 financial crisis were based on the concept of “incurred losses.’’ These standards were criticized for excessively delaying banks’ recognition of credit losses (Financial Stability Forum 2009). In response, the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board introduced new provisioning rules based on the concept of expected loss: CECL in the U.S., and International Financial Reporting Standard (IFRS) 9 in the rest of the world. The new provisioning standards require financial institutions to be more timely in recognizing credit losses that are expected to occur over the life of the loans. The idea behind this forward-looking approach is to discipline risk-taking in good times and to prompt earlier corrective actions in crisis times. The Covid-19 crisis puts the banks’ provisioning models back under the spotlight.

The CARES Act provides an option to delay the implementation of CECL until Dec. 31, 2020, or the end of the coronavirus national emergency, whichever comes earlier. On the same day that the CARES Act was signed into law, the board of governors of the Federal Reserve issued an interim final rule (CECL IFR) that provided an optional extension for banks to delay CECL’s impact on regulatory capital by two years. Note that banks cannot have their cake and eat it too: those who do not implement CECL would not get the full benefit of the capital relief. Interesting, in the EU, policymakers did not delay the implementation of IFRS 9. However, on April 16, the European Central Bank decided to temporarily loosen the capital requirements for banks in order to spur lending by banks and to support the economy. Similarly, to mitigate the impact of IFRS 9 on bank capital, the European Commission has proposed that banks should be allowed to add back to their regulatory capital any increase in expected credit losses provisions that they recognize in 2020 and 2021.

We believe that giving banks the option to delaying the implementation of CECL and IFRS 9 during the current crisis is potentially misguided. In current research with Gaoqing Zhang at the University of Minnesota, we show that the role of expected loss models such as CECL and IFRS 9 is to reveal timely information about credit losses so that banks’ stakeholders are more nimble in making informed and sound decisions. Ignoring such information would not discipline risk-taking but could potentially exacerbate risk-taking. As governments and central banks are providing much of the cash to banks to spur lending, banks are required to perform the difficult task of figuring out which companies should receive assistance and which companies would have struggled regardless of the current pandemic. Stated differently, it is precisely during uncertain times that bank management, bank board members, and bank regulators need to monitor credit risk more carefully and relying on expected loss models provides such an opportunity.

There have been arguments that the growing economic uncertainties stemming from the pandemic and the rapidly evolving measures to confront related risks, make certain allowance-assessment factors potentially more speculative and less reliable at this time. While such arguments are potentially valid, they present only one side of the coin. The costs of such noisy estimates should be weighed against the benefits of this information to the stakeholders of the bank. Recognizing these losses would better discipline management and the board. Disclosing such information to outsiders would help increase management credibility during this period of heightened uncertainty.

There have also been arguments that relying on expected loss models would curb lending because banks would face a capital crunch. For instance, in an April 30 letter to the FASB, the chairman of the National Credit Union Administration, is pushing for credit unions to be exempt entirely from CECL. However, such arguments only make sense if banks’ capital requirements are set independently of the accounting standards used to provision for loan losses. Our research shows that capital requirements and loan loss models are inherently linked. If banks change the methodology they use to estimate loan losses, then banking regulators should also adjust banks’ capital requirements. In another recent working paper with Jeremy Bertomeu, at the University of California San Diego, we show that accounting measurement and capital requirements are complementary tools that affect the level of credit in the economy, and we call for a better coordination between accounting standard setters and prudential regulators.

The rationale for coordinating bank regulation with accounting standards is straightforward: if banks become more timely in recognizing loan losses on their financial statements as in an expected loss model, then the banks’ levels of capital would also become more sensitive to the riskiness of their loan portfolios. Such increased sensitivity, in turn, would allow banking regulators to better tailor banks’ capital requirements to the riskiness of their loan portfolios. More precisely, our current research shows that if expected loss models provide accurate estimates of loan losses and/or the banks’ risk-taking incentives are not too severe, then implementing expected loss models would actually relax capital requirements and spur lending not necessarily constrain lending. This will benefit lenders as well as the whole economy. Consistent with our predictions, a large number of publicly traded U.S. banks opted to go ahead and comply with CECL. Doing so allows them to better monitor their risks and at the same time get capital relief.

The U.S. Congress and the European Commission have recognized the importance of the link between accounting standards and capital requirements. Interestingly, the insight from our research to implement CECL and to simultaneously adjust and potentially relax capital requirements is consistent with what the Fed is indirectly achieving via the CECL Interim Final Rule: for those banks who elect to continue to comply with CECL during the coronavirus, they will be granted temporary capital. On the contrary, for those who do not comply with CECL, there is very little capital relief. Similarly, in Europe, banks do not have the option to delay the implementation of IFRS 9 but will benefit from looser capital requirements. Our research argues this is indeed the right prescription.

One silver lining of the current pandemic is that it underscores the importance of adjusting regulatory capital to the accounting standards. The sooner regulators and standard setters work together, the better-prepared banks will be from weathering this unfortunate crisis.

References

Bertomeu Jeremy, Lucas Mahieux, and Haresh Sapra (2018), ‘Accounting versus Prudential Regulation’, SSRN Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3266348

Mahieux, Lucas, Haresh Sapra, and Gaoqing Zhang (2020), ‘CECL: Timely Loan Loss Provisioning and Banking Regulation’, SSRN Working Paper, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3523321

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Lucas Mahieux is an assistant professor at the School of Economics and Management, Tilburg University in Tilburg, Netherlands.

Haresh Sapra is the Charles Horngren professor of accounting at the University of Chicago Booth School of Business.

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