COVID-19 Offers the First Big Test for the CECL Accounting Standard—Banks Have to Adjust
John DelPonti, Joseph Sergienko and Paul Noring
No models could have foreseen the depth of our current downturn, but executives can take action to mitigate risk.
The current expected credit losses (CECL) accounting standard that was put into place after the global financial crisis has faced questions since its inception. Assuming its implementation to mid-size institutions will not be delayed, we might soon receive answers.
When banks set their CECL reserves earlier this year, they might have accounted for a mild recession, especially given talk late last summer of a downturn. But it’s doubtful they foresaw the havoc being wrought by COVID-19: the stalled economies, slashes in consumer spending and our first bear market in over a decade.
The crisis sets up a real test for the CECL model, and its critics have predicted it will reduce banks’ ability to lend under stress rather than allow it to continue as intended. As the Bank Policy Institute (BPI) noted:
CECL forces banks to recognize expected future losses immediately but does not allow them to recognize immediately the higher expected future interest earnings banks receive as compensation for risk. Banks are thus forced to recognize the risk but not the return. The inevitable result will be a decrease in lending and other bank intermediation. CECL will magnify this effect during an economic downturn, as projected losses over the life of the loan will increase.
The only way around this issue, BPI later suggested, would be if banks had perfect foresight. Yet if such foresight was difficult before, COVID-19 has now perhaps shown it to be impossible.
For banking executives, hedging against CECL models with out-of-date economic forecasts is a matter of great consequence—to not only their institutions but the economy more broadly. So what can they do?
Managing credit and the CECL account standard amid increased uncertainty
First, executives could move quickly to revise their scenario assumptions and consider the impact certain revisions would have on the reserving process. Given the present uncertainty, it might be difficult to reasonably update those scenarios and rerun the model.
A better approach may mean releasing revised guidance and considering a management overlay to model results to account for the uncertainty. For instance, if a bank reserve was going to be $1 million, perhaps it could add $500,000 to this estimate to be safe. Another alternative is to probability-weight a variety of scenarios and reforecast the CECL estimates.
Second, executives should identify and pull susceptible credits, and ask if they have allocated appropriately given those credits. They should also review existing covenants and collateral, assessing their impact on CECL’s ability to collect if the loans default.
Third, it’s vital now to monitor a bank’s entire book of loans on a real-time basis. Executives might take lessons from the market crash more than a decade ago. Then, the inability to follow the money was one of banks’ biggest problems: the bank would provide a loan, say, to an IT company, which provided services to a travel agency, which in turn couldn’t pay its bills back to the IT company, which as a result couldn't pay its loan back to the bank.
In our current downturn, where various segments of the economy will fall atop one another as one fails—like dominoes—banks need to understand their customers and the flow of funds.
Executives need to monitor and report shifts quickly enough that they can actually act rather than merely react. In addition to understanding customers’ global cash-flow needs, banks must install best practices to include daily flash reports and checking in with customers.
“Executives need to monitor and report shifts quickly enough that they can actually act rather than merely react.”
Whether CECL models emerge unscathed from the crisis remains to be seen. Some, like the FDIC, have already urged the Financial Accounting Standards Board “to exclude COVID-19-related modifications from being considered a concession when determining a troubled debt restructuring.” Others have proposed fundamental fixes, such as making reserves a function of observed industry loan growth rates (thereby allowing for CECL’s desired countercyclicality, with allowances high when lending growth is high and vice versa). COVID-19 is also prompting the question of whether CECL could be rolled backed to an incurred loss model for those that have already implemented.
In the meantime, taking tangible steps to adjust these models, make revisions and improve real-time monitoring and reporting processes can make a significant difference in banks’—and our economy’s—well-being during these trying times.