Credit Transparency

For better or worse, public companies must disclose their expected losses.

What a difference a word can make. As of January 1, publicly traded US corporations have had to record credit losses when they are “expected” rather than “probable.” That nomenclature shift could be enough to force banks’ reserves up 30%, tightening credit when the next recession comes, says Gregory Norwood, Risk and Financial Advisory managing director at Deloitte & Touche. “Bankers say that increasing reserves decreases their ability to lend in a downturn,” he says.

The villain, or hero, here is the new “current expected credit loss” (CECL) standard devised after long years of deliberation by the US Financial Accounting Standards Board (FASB). It reaches beyond banks to any entity that extends medium- or long-term credit: automakers and dealers, retailers with in-house credit cards or installment plans, and others. In theory, any company with accounts receivable—effectively credit to customers—must apply the new standard; though loss calculations are unlikely to change for terms of a year or less.

Compliance with CECL is enormously complicated by the FASB having framed it as a “principle-based” standard. Companies are free to achieve it as they wish, so long as their methodology is “reasonable and supportable.” That’s set off a scramble among the 600 publicly traded US banks to get their reasonable and supportable methods in place in advance of first-quarter financial statements, where CECL makes its debut. “There’s no checklist,” says Barry Pelagatti, a partner at Lancaster, Pennsylvania-based audit firm RKL. “No one can provide a solution and say, ‘This is CECL compliant.’”

Accounting standards are the supertanker of financial regulation: slow to turn but cutting a wide swath once they pick up steam. The quest for more-stringent loan-loss accounting dates back to the 2008-2009 financial crisis. Until then, lenders and creditors used a 12-to-15-month horizon, provisioning at the beginning of each reporting year for loans that looked likely to become delinquent. That approach proved inadequate, to say the least, in the face of surging defaults on mortgages and other assets that had been counted on to produce income for years into the future.

The grandees who set US accounting principles intended to forge a new global prudential order with the overseers of international financial reporting standards (IFRS). But somewhere along the way, the bodies “agreed to disagree,” says Jonathan Jacobs, global financial services industry leader at advisory firm Duff & Phelps.

With CECL, FASB is requiring US corporations to somehow forecast risk for their entire loan portfolio over the full life of the instruments involved. Guesstimates may really be too weak a term to describe banks’ widely ranging early loss estimates under CECL, Pelagatti says. “You have one institution saying their reserves need to go up 30%,” he relates. “You go down the street 20 feet and another says they may go down because their loans are not risky at all.”

The international standards group opted to slide between that maximalist approach and the old status quo, implementing an “expected credit loss” standard—also known as directive IFRS 9—in 2018. This mandate also requires losses to be provisioned for the length of the loan, but only applies to credits already at risk. That effectively limits the forecasting horizon to two to three years, Jacobs says, and constrains the leeway for judgment calls. “There’s a lot less guesstimating and a lot less volatility in the IFRS approach,” Deloitte’s Norwood affirms.

The divergence between the two is not surprising, considering the scope of the task: projecting risk for a mortgage portfolio decades into the future, for instance. Issuing banks may sell off mortgages after an average of about seven years, Pelagatti says. But that raises another problem. The seven years preceding January 1, 2020, were healthy ones for the US economy, with below-average defaults. Using that record to forecast the next seven could undermine the basic objective of building adequate buffers for the next crisis.

Then there are devilish details of untapped credit lines available through plastic cards or home equity loans, Jacobs adds. Do lenders need to reserve against amounts currently outstanding, or all the extra cash borrowers might draw down if stressed in a weaker economy? “These off-balance-sheet obligations are where you’re going to see the really big swings in reserves,” he says. “Basic corporate and mortgage lending should be more consistent.”

Finding the Right Path

Seen in a more positive light, CECL gives US financial institutions and their shareholders a massive opportunity for what might be called bottom-up regulation. Starting with the Q1 reports this spring, banks and other lenders will be, as it were, throwing their compliance methodologies at the wall and seeing what sticks—with investors looking for the right balance between aggressiveness and prudence, and with an array of regulators who may step in if they choose: the Securities and Exchange Commission, various banking watchdogs or the Public Company Accounting Oversight Board. “You should start to see convergence in CECL approaches as investors, clients and auditors have time to analyze the disclosures,” Jacobs says. “But it’s going to take at least a year.”

Big banks, already subject to Federal Reserve Board “stress tests” under post-2008 legislation, may have capabilities in place to shift to CECL. The mass of smaller institutions will try to keep their own compliance costs down while waiting for industry standards to emerge. “Smaller public banks are caught in the middle here,” Pelagatti says. “They have the same requirements as the money-center banks, but not the money to fund solutions.”

Companies outside the financial sphere might feel the effects of CECL as banks rein in loan books. A 30% jump in reserves requirements sounds like it would leave less capital to lend out. And it might, Deloitte’s Norwood says, but not at this peculiar economic moment, because the US economy is awash with cheap funding and business for most borrowers is solid. “We don’t see the effects in the current benign environment,” he says.

It’s a fair bet the benign environment won’t last forever, though. The next downturn will show not only whether CECL constricts credit, but whether the whole complex CECL game is effective in making banking more stable and avoiding the massive government bailouts of a decade ago. For now, the one sure result is much more work for risk analysts and auditors. “A lot of people find this standard challenging,” Norwood notes. “It will take us a while to figure this out.”