The FASB’s new standard on accounting for credit losses on financial instruments will affect US banks’ reserving practices, says Fitch Ratings. However, it will be manageable as banks have adequate time to prepare for implementation.
The new standard will require institutions to estimate credit losses for loans and debt instruments, financial guarantees and noncancellable loan commitments and disclose credit quality indicators by vintage year. Forward-looking reserves and enhanced disclosures will be helpful to analysts, although there may be some unintended consequences.
Fitch expects the transition to current expected credit loss (CECL) model will, in aggregate, result in higher reserves for credit losses than under the current “incurred loss” model. The transitional adjustment will be applied to the beginning balance of retained earnings at adoption in 2020 (or 2019 for early adopters), bypassing earnings.
If CECL were implemented today, we estimate loan loss reserves would increase by $50 billion to $100 billion, which would translate into a 25bps-50bps hit to tangible common equity ratios across the US banking system in aggregate. Fitch’s analysis used simplifying assumptions and focused on loan portfolios and loan commitments, and excluded securities and financial guarantees. We used regulatory data, historical average loss rates by asset type and Fitch’s assumptions of expected loan lives and credit conversion factors. This is not meant to be construed as a technical application of the standard.
Aggregate data masks individual outliers and some banks will be better positioned than others. Our estimates do not consider potential future changes from evolving regulation, macroeconomic conditions, technological disruptions and lenders’ behavioral motivations. The day-one impact on individual institutions will vary based on reserving practices, loan type, economic assumptions, credit quality and tenor. Much will depend on the economy and expectations at implementation.
Changes to systems and processes to estimate credit losses may be required. The standard does not specify a method for calculating expected credit losses, and the level of data robustness that auditors will deem sufficient is unclear. Auditors may have concerns over auditing economic assumptions and management judgment used in CECL estimates. We believe the transition will be operationally simpler for advanced approach banks with robust data warehouses to leverage.
Expected loss estimates will be more sensitive to management’s judgment under CECL models as it generally covers a longer time horizon and sudden changes in economic conditions will create earnings volatility. The new rule could incentivize banks to originate loans earlier in a reporting period, as full provisions are taken upon origination while the interest is recognized in earnings over the life of the loan. Banks may be less inclined to offer noncancellable loan commitments or raise costs of commitments as reserves must be recorded up front. Unused credit card lines and home equity lines of credit, which Fitch estimates to be $3.8 trillion at year-end 2015, are excluded as these are deemed unconditionally cancellable.
The change to a CECL model will require banks to estimate credit losses over the life of certain financial assets using economic forecasts and historical data. Allowances must be recorded in the same period instruments are originated or purchased. Today, banks estimate credit losses over a shorter horizon and only when losses are deemed “probable”. This represents a timing difference of when reserves are established; however, actual credit losses realized will remain the same.
The International Accounting Standards Board released a similar standard, IFRS 9, although there are important differences between the two standards which will inhibit comparability. The IFRS 9 model is operationally more complex but provisions will be lower (all else equal) than under CECL.
