Halt in accounting rules will allow banks to lend and business to run

Halt in accounting rules will allow banks to lend and business to run
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While the economy is sick from the coronavirus, the last thing it needs are new accounting rules that will discourage bank lending to consumers and businesses. The government should thus require the Financial Accounting Standards Board to immediately suspend its current expected credit loss rules for at least two years to encourage banks to continue lending.

When a bank makes a loan, in most cases, it expects the loan to be repaid in full. Banks will appreciate that unanticipated economic conditions can delay or curtail scheduled loan payments, and they compensate for these risks in the interest rates they charge borrowers. A properly underwritten loan for $100 is worth $100 when it is made because the bank expects to receive full principal and interest payments under most conditions, but it has priced in an interest rate premium to fairly compensate the bank for those rare occasions when full and timely payments are not received.

But some properly underwritten bank loans still go bad. Under traditional rules, when information suggests that a loan may not be repaid in a timely manner, banks have to establish a loan loss reserve. The loan loss reserve marks an expense that reduces bank income and reduces the loan value on the books. If the bank makes a one year loan for $100, and information six months later suggests that the bank will only be repaid $80, then the bank would establish a $20 loss reserve for that loan. This would reduce bank income by $20 and reduce the loan value on the books to $80.

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In the last two decades, economic modeling has become pervasive in all phases of financial institution operations. Accountants have imposed yet another use of complex models now, and banks will soon be required to use current expected credit loss models to calculate loan loss reserves. Banks must build models that can produce estimates of how their loans will perform under all possible economic scenarios with these rules.

There are difficulties associated with loan loss models as a function of future economic conditions. But the use of such models is not the main problem with the new rules. The issue is how the Financial Accounting Standards Board requires that current expected credit loss estimates be used. The new rules require financial institutions to estimate loan losses over the life of a loan under each possible future economic scenario, take the average of loan losses across all scenarios, and book the average loss estimate as a loan loss reserve at the time when the loan was initiated.

Assume that in 95 percent of all future economic outcomes that the loan above fully pays $100 at maturity, and in 5 percent of possible scenarios the borrower repays only $80. The expected loss at loan initiation is $1. When the bank makes the $100 loan, it will pay $100, but under current expected credit loss accounting rules it books a loan loss expense of $1 and records a new asset worth $99. Facing other mounting losses from a recession, it would be unusual for any bank to want to make this loan if it were required to use the current expected credit loss accounting rules.

Moreover, when the economy is at the precipitous of a potentially deep recession, such models will project very large loan losses. As you might imagine, if banks are required to use the new expected credit loss rules, many could be reluctant to make new loans that instantly raise expenses and seem like they are making deeply underwater new loans. The timing of the Financial Accounting Standards Board could not be any worse.

Prior to the coronavirus, experts predicted that the transition to current expected credit loss rules would require banks to make adjustments in balance sheets and retained earnings. Large banks are only now being required to use current expected credit loss, and these banks were not allowed to build reserves before the methodology became mandatory. Even before the crisis today, the impact of current expected credit loss rules has been hard to predict because each bank might use a different model methodology and loan portfolios vary widely across the sector.

On top of this uncertainty, layer on the economic impacts of the looming recession. It is clear that the earnings impact of current expected credit loss rules could be a minor disaster for several banks. The markets would have trouble differentiating weak banks from strong banks, and these new uncertainties could trigger widespread bank funding difficulties. It is time to use some common sense and suspend the implementation of current expected credit loss standards for at very minimum the next two years.

Paul Kupiec is a resident scholar with the American Enterprise Institute in Washington. He served as the director of the Center for Financial Research at the Federal Deposit Insurance Corporation and is the former chairman of the Research Task Force for the Basel Committee on Banking Supervision.