The implementation of a new accounting standard that changes the way banks reserve for loan losses could have a far more punitive impact on community banks than their larger counterparts.
The accounting standard, known as the current expected credit loss model, or CECL, becomes effective for many institutions in 2020 and will require banks to set aside reserves for lifetime expected losses on the day of origination.
The new standard will mark a considerable shift in how banks currently reserve for losses. Today, banks record losses when it becomes probable that a loan will be impaired. That means reserves are dispersed over time, but CECL will cause banks to significantly build their allowance for loan losses on the date of adoption, according to Josh Siegel and Ethan Heisler.
The two bank observers said in the latest Street Talk podcast that the increase will be even larger for institutions with higher concentrations of longer-term loans since reserves for those credits are currently spread out over longer periods.
“The same credit, the same view, the same company, if you have a two-year loan or a 20-year loan, the reserve you’re going to have to put it against it is dramatically different,” Siegel, managing partner and CEO of StoneCastle Partners LLC, an investor and adviser to community banks, said in the episode.
He said a reserve for a loan with a two-year term under CECL might not be dramatically different than the current methodology since it requires banks to look ahead 12 to 18 months for losses. Loans with far longer terms such as real estate credits, however, could require multiples of currently required reserves. The burden of the new accounting standard could prove far greater for community banks since those institutions are much more heavily concentrated in real estate.
Siegel and Heisler — president of the Bank Treasury Newsletter, which highlights industry trends impacting bank treasurers — co-authored a white paper analyzing CECL’s impact on banks with less than $50 billion in assets. The analysis found that hundreds of banks could be at risk of falling below well-capitalized status after adopting CECL, at least when it comes to meeting total risk-based capital requirements. Any reserve build required through CECL will be deducted from capital and could have the greatest impact on total risk-based capital ratios because the Basel III rules cap the inclusion of reserves at 1.25% of risk-weighted assets.
The required build under CECL could push reserves well above that level, according to Siegel and Heisler’s analysis. They examined the banking industry’s results since 2004 and assumed institutions adopted CECL beginning in 2005. The analysis further assumed that all loan portfolios had five-year terms, loans were originated at year-end and bankers were fully aware of the losses that would come between 2005 and 2016. The analysis assumed provisions equaled cumulative net charge-offs in the five years after adoption and considered a number of scenarios, with CECL implementation beginning in different years.
In the most severe scenario, where banks would have adopted CECL beginning in 2007, the analysis found that banks in aggregate would need as much as $70 billion to repair the capital shortfall. In the least severe scenario, with CECL adoption beginning in 2011, banks would need to raise close to $10 billion.
“It’s not just a small change. You could today be very well-capitalized and wake up and not even be adequately capitalized,” Siegel said. “You could be deemed undercapitalized and immediately be put under a cease and desist order.”
Siegel said banks should begin calculating CECL’s impact, even in a rough approximation, to see if they have a capital shortfall. For an institution falling short, they recommended that banks should consider issuing subordinated debt to bolster their balance sheets.
Siegel has encouraged community banks to utilize sub debt in the past, given that it allows banks with holding companies to raise funds, downstream them to their banking subsidiaries and count them as equity capital in far more cost-effective manner. He and Heisler noted that issuing sub debt today remains relatively cheap while interest rates continue to be low.
“Sub debt is a natural offset, a way to prepare for CECL,” Heisler said in the episode. “Think of Tier 2 sub debt almost as a CECL buffer.”