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Congress should stay out of new bank rules on loan losses

The Honorable Sheila C. Bair

As I was growing up, my Depression-era parents always preached the importance of having a rainy-day fund to deal with the economic hardships life inevitably throws at you, such as job loss or illness.

Later, as a bank regulator, I valued the similar funds banks set aside to cover losses they would invariably incur on some loans. Unfortunately, in the lead up to the 2008 financial crisis, those funds — called loan loss reserves — were woefully inadequate primarily because of accounting constraints that some bankers rightfully complained about at the time.

But now that accounting standard-setters are trying to improve those rules, industry lobbyists want Congress to help them preserve the status quo.

The rules from 2008, which are still in place, say that banks can only set aside money to cover losses that are “estimable and probable”. This essentially means that borrowers need to be well past due on their loan obligations before banks can start reserving for losses. This is akin to starting your rainy day fund after you have received a lay-off notice from your employer. By the time you see real trouble, it is too late to prepare. This was the case during the financial crisis, as bankers were desperately adding to reserves in 2008 and 2009 just as their earnings were plummeting.

Now the Financial Accounting Standards Board, which sets US rules, wants to switch to a new rule, known by the name of “current expected credit losses” or “CECL”. It says that banks should set aside enough to cover expected losses throughout the life of a loan, taking into account a wide variety of factors, including historic loss rates, market conditions, and the maturity of the economic cycle.

The new rule has two key benefits. First, banks will start putting aside money on day one of each loan so when trouble does hit — as it did in 2008 — they will not be trying to play catch-up with their reserves. Second, it should make bankers a little more cautious in their lending decisions, as they will have to account for likely losses when the loan is made, not kick the can down the road until the borrower is actually in arrears.

Transitioning to the new rule will obviously require banks to add to their loan loss reserves. Now is a good time to do so, while banks are profitable and the US economy is strong. But these reserves will need to come out of earnings, meaning that banks will potentially have less money to distribute to their shareholders. So bank lobbyists have convinced a handful of people in Congress to introduce legislation delaying CECL to allow time for more “study”.

Trying to draw elected officials into this debate is ill-advised. The process of setting accounting rules is, by design, insulated from the politics. FASB is an independent, non-profit organisation of leading, private accounting experts, recognised by the Securities and Exchange Commission as the accounting standard setter for publicly traded companies. FASB spent many years asking for public and industry input before finalising CECL in 2016.

Investors rely on good-quality financial statements and do not want accounting rules subject to the vagaries of the election cycle. Getting Congress more involved in this process could well backfire on the banks, depending on who is in power. Today they are tinkering with rules around loan losses. Tomorrow it could be rules around environmental and social issues.

Regulators have given big banks three years to phase in the impact of the new standard on capital. CECL will not apply to community banks and credit unions until 2023. Banking supervisors can and should work with the institutions they oversee to ensure a smooth transition. Congress should not intervene.

The Federal Reserve is once again cutting interest rates, citing weaknesses in manufacturing and business investment, slowing global growth and trade tensions. Rainy days may be upon us sooner than we think. Instead of resisting CECL, banks should be celebrating the new standard. It will ease the constraints they were under prior to the financial crisis and allow them to adequately prepare for the next storm.

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