New phase-in option for credit losses standard
Bank regulators have completed a rule that will allow banks to phase in the capital effect of the new credit losses accounting standard over a three-year period. The relief comes amid growing banker angst about the impact of the sweeping new accounting standard.
FASB responds to financial crisis
Accounting Standards Update (ASU) No. 2016-13, Financial Instruments — Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, goes into effect in 2020 for publicly traded financial institutions. Published in June 2016, the standard replaces existing requirements under U.S. Generally Accepted Accounting Principles (GAAP) that allow banks to estimate losses only after they’re “probable.”
In practice, the existing guidance has often meant that loan losses are accounted for only once borrowers default. During the financial crisis, investors, regulators and banks said loan loss provisions were recognized “too little, too late.”
The updated credit losses standard, often referred to as the current expected credit losses (CECL) standard, is considered the Financial Accounting Standards Board’s (FASB’s) signature response to the 2008 financial crisis. The standard applies to all businesses. But it mostly affects banks, particularly how they account for souring loans.
In a nutshell, the CECL standard erases current restrictions on using forward-looking information to calculate loan losses. Instead, banks and other creditors must look to the foreseeable future, assess current conditions, take historical experience into account and come up with a reasonable estimate of expected losses.
The new standard requires banks to estimate and book losses on the day they issue a loan instead of waiting for customers to miss payments to set aside loan loss reserves. The increase in loan loss reserves means banks will have to shore up the capital they hold for regulatory purposes.
In turn, when banks increase their capital levels, they have less money available to lend to customers. The standard also may force banks to curtail lending to riskier customers. So, banks have been pressuring the FASB, regulators and lawmakers to either change parts of the CECL standard or stall its implementation.
Standard sparks controversy
The drumbeat against the CECL standard has intensified as banks prepare to follow the sweeping new rules. Recently, the American Bankers Association (ABA), several individual banks and some lawmakers have appealed to the FASB and the Financial Stability Oversight Council (FSOC). In December, a group of congressional leaders sent a letter to Treasury Secretary Steven Mnuchin, who chairs the FSOC, to delay the compliance date.
“Banks have long been concerned about CECL’s cost and impact on our ability to serve our customers and communities, particularly in times of economic stress,” ABA president Rob Nichols said in a statement. “That’s why ABA believes CECL must be delayed until a quantitative impact study can be conducted and the economic consequences of the accounting standard are fully understood.”
Regulators offer partial relief
In response to these appeals, banking regulators have finalized a rule that aims to help banks deal with the regulatory capital impact of the CECL standard. It offers banks the option to phase in over three years the “adverse effects” on regulatory capital that banks expect to feel when they adopt the standard.
“We’re very appreciative the agencies have moved forward by finalizing the rule,” said James Kendrick, vice president of accounting and capital policy at the Independent Community Bankers of America. “We would have rather seen five years. But we think three years would be welcomed by most, if not all, community banks.”
The regulatory rule was a joint effort between the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve and the Office of the Comptroller of the Currency (OCC). The final rule largely follows a proposal issued by the regulators in April 2018.
When the regulators issued the proposal, Regulatory Capital Rules: Implementation and Transition of the Current Expected Credit Losses Methodology for Allowances and Related Adjustments to the Regulatory Capital Rules and Conforming Amendments to Other Regulations, for public comment, many banks applauded the move to offer relief.
However, several banks and professional groups asked to be allowed to phase in the capital hit over five years instead of three. Others took the opportunity to air grievances about the standard in general, calling on the regulators to force the FASB to make changes to the standard or conduct a formal cost-benefit analysis of the impact of the standard before allowing it to be implemented.
Are you ready?
The option to phase in the CECL standard over three years is an important step toward easing its adoption. The phase-in is also expected to give regulators time to understand how the new accounting rule could affect banks’ day-to-day operations.
Have questions? The FASB provides answers
In January, the Financial Accounting Standards Board (FASB) issued informal guidance to help banks understand acceptable methods of quantifying losses under the updated credit loss standard. Most of this question-and-answer document deals with a “practical” method to calculate loan losses known as the weighted average remaining maturity (WARM) method.
“If an entity is using a loss rate–based method today, that entity may be able to continue with a comparable method, including the WARM method,” says the FASB’s guidance. “However, compared with the method it uses today to estimate incurred losses, the entity’s assumptions and inputs will need to change to arrive at an estimate for expected credit losses that contemplates the contractual term of the financial assets adjusted for prepayments as well as reasonable and supportable forecasts.”
The WARM method essentially is a simplified mathematical calculation that uses an average annual charge-off rate to come up with losses. That rate is used as a foundation for estimating the credit losses for the remaining balances of assets in a pool at the balance sheet date.
The average annual charge-off rate is applied to the contractual term, further adjusted to account for estimated prepayments. Then it’s used to determine the unadjusted historical charge-off rate for the remaining balance of the financial assets.
Though the WARM method is acceptable, the FASB reiterates that the credit losses standard is flexible and doesn’t prescribe a specific method for tallying losses. Under the standard, “the allowance for credit losses may be determined using various methods.”
Such flexibility is permitted, because banks and other businesses manage risk differently depending on such factors as size, access to information and portfolio management. Your CPA can help determine the appropriate method for estimating credit losses based on your situation.