COVID-19: How Could Regulators Alter CECL to Provide Relief to Banks?

THE COWEN INSIGHT

Banks and regulators have long complained about the Current Expected Credit Loss approach to loan loss reserves. Despite the complaints, FASB implemented the policy for publicly traded banks on Jan. 1. While we question if FASB would revoke CECL, we believe regulators could ignore the accounting rule when looking at bank capital. That could help boost lending during the crisis.

What is Happening

There is increasing talk that bank regulators will provide relief from the Current Expected Credit Loss approach to loan loss reserves.

Our View

• Such a change should encourage banks to boost lending during the COVID-19 crisis as they would have more capital, which means they could support more loans.
• We question if FASB would repeal or delay the rule, but we see options for the regulators to offer enough relief to offset any negative hit to capital from CECL.

Full Note

We have long argued that the Current Expected Credit Loss approach to loan loss reserves could end up being pro-cyclical by forcing banks to move capital to reserves during times of stress. This would then reduce the ability of banks to extend new loans. Our view is that we are seeing this play out today as expected credit losses on pools of similar loans would be far higher today than just a few months ago. That means banks would need to set aside more in reserves, which may help explain some credit issues now in the market. The question is what can be done? We note the following:

• It would be extraordinary for the Financial Accounting Standards Board to reverse course so soon after the rule took effect. In addition, the rule’s biggest proponent is FASB Board Member Hal Schroeder, whose term extends until June 30, 2021. We have trouble seeing FASB rebuke Schroeder on this proposal while he remains on the board.
• In addition, FASB already delayed compliance for a year for most banks and credit unions. So this is only an issue for the publicly traded banks, which implemented CECL on Jan. 1. We believe there are practical challenges to undoing the systems that the banks were forced to adopt. And we question if banks would want to change their systems during such volatile times. It took years to build the CECL approach into their accounting process. We question if it would be simple for all these banks to turn it off and go back to the prior approach.
• This is why our focus is on what the banking regulators could do to offer relief while not dismantling the existing CECL framework. To us, there are paths forward here that would help banks but not involve FASB.
• Bank regulators already gave banks a three-year window to phase in the hit to capital from CECL on their existing loan book. We suspect many banks simply took the hit at once rather than use the phase in, but this would be a way to offer relief to those banks that are phasing in. The regulators could simply freeze the phase in so year 2 would start in 2022.
• Consistent with freezing the rule on the existing loan book would be to provide relief on new loans or for banks that did not phase in. We believe this could be done by changing the definition of Common Equity Tier 1 capital to include a potion of loan loss reserves. This could either be tied to the amount of capital that is pulled out for CECL or a set percent of loan loss reserves could count as CET1. The CET1 definition today requires a deduction for the amount needed to fully fund loan loss reserves. So this would also alter that requirement.
• The advantage of this approach is that banks would not be drawing down their capital each time they originated a new loan. That could encourage banks to extend credit which would address one of the concerns about financial markets today.
• This also would be similar to how the Federal Reserve handles CECL in CCAR where it is phasing in the impact over three years rather than all at once.
• We believe this is the type of change that regulators could adopt with an interim final rule, which means it would be effective immediately and would not have to wait for public comment. It is also something the regulators could do quickly, which is why we believe the prospects favor action in the next few weeks.