This transcript is taken from an interview conducted April 6, 2020.
How have banks changed how they recognize losses since the financial crisis?
Since the 2008–09 financial crisis, one of the biggest changes in terms of accounting standards is the way that banks recognize losses on their loan portfolios. After the crisis, a lot of the banks were viewed to have been slow in recognizing losses on their loans. Even though they knew about the losses, they were slow to react and to recognize them on their financial statements. They used what is called an incurred-loss model—they did not recognize losses until they had been incurred or were probable. The incurred-loss model was viewed as too slow at recognizing losses. By not recognizing losses, banks were not disciplined in their lending behavior. When the financial crisis hit, most banks stopped lending because they had to write off those loans and consequently had to write down their capital.
As a result, the accounting standard for recognizing losses was replaced by an expected-loss model. Regulators on both sides of the Atlantic—the International Accounting Standards Board (in London) and the Financial Accounting Standards Board in the United States—changed the way that banks recognize losses. These rules were debated for a long period of time and were finally put in place in 2016. Then they kept getting delayed and delayed, but in 2018, all banks or companies outside the US were required to recognize the expected-loss model; for US banks, these new standards came into force at the beginning of 2020.
Everything was going well until the coronavirus hit. Then many banks started complaining and saying that this is not the right time to implement these standards. Why? First of all, these uncertainties caused by the virus will result in a lot of losses, and banks will have to write off loans. These loans will hit their capital, and hitting their capital would hinder lending in the economy, they say.
In light of all the pushback, the Coronavirus Aid, Relief, and Economic Security (CARES) Actthat President Trump signed on March 27, 2020, included one short paragraph—on page 538 of an 880-page document—allowing banks to delay implementation of this expected-loss model, which in the US is called the CECL (the current-expected-credit-loss model). President Trump signed it into law, allowing banks to delay implementation of the CECL—to the end of 2020, or when the coronavirus ends, whichever comes earlier.
Banks are not the bad guys here, but they have an opportunity to be the good guys, because in being careful in helping to channel this money to the right companies, they could help spur the real economy.
I don’t think that is a good thing, because this standard has been debated at length, and banks had already started implementing it. This is precisely the time when banks need to be monitoring the risks of borrowers. The idea is that the government is sending all of its money to borrowers, to companies, to try to invest, and banks need to be figuring out to whom to lend money. Are they lending it to companies that really need it because they’re struggling now, or are they lending it to companies that would have struggled regardless of the coronavirus? This is precisely what the expected-loss models do, help banks answer these questions.
How do expected-loss models help banks improve lending?
The idea is that [banks] are monitoring risk carefully, and they’re using this risk model to write down loans, so they’re being proactive about identifying risky borrowers. There’s a lot of uncertainty in the economy, and board members, executives, and managers need to get this information so that they can make sound and efficient decisions. Delaying implementation of the standard is not a good idea.
Interestingly, the Federal Reserve is saying that if companies or banks continue to use the CECL, they’ll give them capital relief. That’s a good idea. Why? Because if you, as a bank, monitor your risk carefully, you can also benefit from relaxed capital requirements, and that would spur lending. This is the best of both worlds. You are monitoring the risk, getting good information about the risks you’re making to borrowers, and at the same time you’re relaxing the capital requirements. That’s a move in a good direction.
Keep in mind that banks have a choice here. Either they delay the CECL and don’t get the capital relief, or they continue using the CECL and get capital relief. The latter, in my mind, is the better option. In fact, this is consistent with something that I’m finding in my research. My coresearchers and I demonstrate, using an economic model, that banking regulators and accounting-standard setters need to harmonize their regulation. In other words, if you require banks to use the CECL, at the same time, you need to see how your capital requirements should adjust in light of banks being more proactive in monitoring their risk.
In contrast, banks would be misguided if they did not use the CECL appropriately, if they essentially ignored the accounting standards and chose the delay, implementing the standards at the beginning of 2021. It’s misguided because it would hurt the real economy. Banks need to be lending—that’s the point of the CARES Act. The government is giving money to banks to lend to borrowers. If we stop lending right now, it would hurt the economy for a long period of time.
But in fact, without the CECL, banks could be lending to the wrong types of borrowers, and then there would be huge write-offs in the future. This would take us back to the 2008–09 financial crisis, when banks were lending money to borrowers who were essentially poor risks. It took a while for us to recover, and we should not make that mistake again.
During the financial crisis, the banks were the bad guys. This is no longer the case. There have been a lot of changes in regulation, such as stress tests—implemented by the 2010 Dodd-Frank [Wall Street Reform and Consumer Protection] Act—and increased capital buffers. Banks are not the bad guys here, but they have an opportunity to be the good guys, because in being careful in helping to channel this money to the right companies, they could help spur the real economy. I view this as a great opportunity, but it would come from banks implementing the CECL appropriately.
Why current accounting rules could stop banks from lending
How the crisis could prompt innovation
The crisis should not delay stricter accounting rules
How politicians and companies can regain trust
What are the biggest challenges companies are facing?
The biggest challenge they are facing is a cash crunch, because essentially everything in the economy has been frozen. Companies are losing their customers. They have to continue paying their suppliers to make sure that they maintain these relationships. So most companies are facing a cash crunch, but it’s temporary, and this is precisely the objective of the CARES Act. The government needs to funnel this money to companies so that they can keep paying their suppliers and their employees while they’re not collecting cash from customers. The customers will come back, but this is going to take time. Most people are at home, and they’re focusing on the most basic needs: toilet paper, masks, and food. Some businesses are benefiting from this, but the general economy is really hurting.
Getting cash from the government, paying employees, and gradually coming back out of this is going to take time and patience. But the important thing is that banks need to keep lending so that companies can keep making their payments. This is where, again, accounting would help, because those companies that are disciplined in their risk-taking, and banks that are properly monitoring these risks, will emerge from this crisis in much better shape.
These are probably the most uncertain times we have faced in the world economy since the Great Depression. Interestingly, though, now we have better accounting systems in place to try to monitor or manage this uncertainty.
This is precisely the time when people want politicians, not just banks, to be trustworthy. . . . Being trustworthy is probably the best medicine right now.
There’s a silver lining in this coronavirus episode. Revenues have shrunk, but companies want to maintain relationships with their employees. This provides an opportunity. Most companies are generating losses, therefore this is the time when they could look at activities such as research and development that they had cut back when they were worried about generating profits. Why not look at the important decisions that they’ve been postponing and start getting employees to think about them? Most of their employees are working from home, away from the distractions of the office. Why not use this opportunity to look at decisions that have been postponed that require large investments? Shareholders are going to be willing to tolerate this type of risk at this moment.
In terms of the accounting, all of this would be recognized as an R&D expense, and so their share prices won’t be hurt as much. I think companies realize it, and going down that path is going to help them. They’ll emerge from the crisis perhaps in much better shape than they think they are in right now.
In the policy debate, the CARES Act is going to be helpful. I also believe that banking regulators providing capital relief to banks is a move in the right direction. What is important to keep in mind is that we need to be patient in terms of how we deal with this crisis, in the sense that executives and managers need to be given time to resolve these issues. If the regulators come out with a unifying message that this is a short-term crisis that will go away, we’ll emerge stronger, and the economy will do better in the future.
It’s interesting to me that every time there’s a major crisis, people talk about accounting. Think of the 2008–09 financial crisis: what came to the forefront was something called fair-value accounting. Banks were marking to market their loan portfolios, and there was a lot of criticism that accounting was causing the crisis. I don’t believe it was. At best, fair-value accounting was revealing the type of risks that banks were taking, and maybe that, perhaps, provided a catalyst for banks to write down their loans.
The same thing is playing out again. There’s a feeling that the way you do your accounting could be making things worse during the crisis. In a crisis, it is important that you build trust. Fair-value accounting allowed banks to be transparent during the financial crisis, and the expected-loss model also allows banks to be transparent during a financial crisis. That’s a message not just for accounting, but for politicians. It’s important to be transparent during a crisis—that way you build trust in the economy and among people. This is precisely the time when people want politicians, not just banks, to be trustworthy. It’s not just accounting; it’s part of everyday life. Being trustworthy is probably the best medicine right now.