Policy makers’ COVID-19 accounting gift to banks

Banks shouldn’t get relief from a controversial standard meant to discipline risk taking

Haresh Sapra

Haresh Sapra | Apr 15, 2020

To jump-start the US economy amid the COVID-19 crisis, President Trump signed the Coronavirus Aid, Relief, and Economic Security Act on Friday, March 27. The $2 trillion package is meant to provide much-needed temporary support for American workers and small businesses affected by COVID-19. It also gives banks various types of temporary relief and support in order to spur lending to small businesses and households. 

But one provision tucked inside the sweeping measure grants banks optional temporary relief from complying with the current expected credit losses (CECL) accounting standard. And this temporary relief—a delay in the implementation of a controversial accounting standard—is potentially misguided.

What does an accounting standard have to do with this crisis? A bit of history might help: during the 2008–09 financial crisis, banks were criticized for excessively delaying their recognition of credit losses by relying on an incurred-loss model, which did not require recognizing such losses until they were highly probable. In response, the International Accounting Standards Board and the US Financial Accounting Standards Board (FASB) introduced new rules—the IFRS 9 and CECL, respectively—based on models that estimate expected losses. Both call for banks to estimate expected credit losses over the contractual life of a loan. The idea is that more-timely loan-loss recognition will both induce cautious lending behavior in good times and prompt earlier corrective action in bad times. 

The CARES Act gives banks the option to delay implementing the new credit-loss standard until December 31, 2020, or until the end of the coronavirus national emergency, whichever comes first. On the same day the bill became law, the Federal Reserve board issued an interim final rule, CECL IFR, that provided an optional extension to delay the CECL’s impact on regulatory capital by two years. This delay includes the original three-year transition period, so banks could potentially put off incorporating the full impact of the CECL on their capital for five years. 

Banks that are timely about recognizing these losses will emerge from this crisis in better shape and with more credibility.

And the Fed did not stop there: on April 1, it announced that it was temporarily easing its leverage rules for large banks by exempting certain investments from a key calculation, part of the effort to ease credit and combat the economic slowdown. Note that banks cannot have their cake and eat it too: those that choose the statutory relief under the CARES Act, and therefore do not implement the CECL, would not get the full benefit of the capital relief.

Bankers have been pressuring the FASB for years to delay implementing the CECL. It took the onset of COVID-19 for Congress to intervene and stop the controversial accounting standard before it fully kicked in. 

Insights from my current research suggest that this decision to delay is potentially misguided. Some argue that due to the economic uncertainty brought about by COVID-19, banks may face higher-than-anticipated increases in credit-loss allowances. But my research demonstrates that the role of expected-loss models such as the CECL is to reveal timely information about credit losses so that a bank’s stakeholders can be more nimble and make informed, sound decisions. Ignoring such information would not discipline risk-taking—and could potentially exacerbate it. Governments and central banks are providing much of the cash to spur lending, but banks will perform the difficult task of figuring out which companies should receive assistance and which of them would have struggled regardless. This is precisely the time that bank management, board members, and regulators need to monitor credit risk more carefully. The CECL provides this opportunity. 

Banks have also argued that the growing economic uncertainties stemming from the pandemic, and the rapidly evolving measures to confront related risks, make certain allowance-assessment factors potentially more speculative and less reliable at this time. Such arguments are perplexing because large and midsize banks have been preparing for the CECL since 2016. Moreover, it is hard to imagine that banks do not have reliable information systems in place to measure and monitor such risks. 

As for arguments that say relying on expected-loss models would curb lending because banks would face a capital crunch, these only make sense if banks’ capital requirements are set independently of the accounting standards used to provision for loan losses. My research demonstrates that capital requirements and loan-loss models are inherently linked. If banks change the methodology they use to estimate loan losses, banking regulators should also adjust capital requirements. The rationale behind such a link is straightforward: if banks become more timely and proactive in measuring and recognizing loan losses, their capital levels will also become more sensitive to risk in their loan portfolios. Such increased sensitivity would in turn allow banking regulators to better tailor banks’ capital requirements to the riskiness of their loan portfolios. More precisely, according to my current research, if the expected-loss model provides good estimates of loan losses, and/or if banks’ risk-taking incentive is not too severe, implementing the CECL would actually relax capital requirements and spur lending—not necessarily constrain it! 

Congress recently recognized the importance of this link and directed the Treasury Department, in consultation with bank regulators, to study the impact of the CECL and to determine whether any changes to regulatory capital requirements are necessary.The research insight to implement the CECL and to simultaneously adjust capital requirements is consistent with what the banking regulators are indirectly achieving via the CECL IFR.

Banks that elect to continue to comply with the CECL during the pandemic will be granted temporary relief and face relaxed capital requirements over five years. For those that don’t comply with the CECL, there is very little capital relief. According to a draft statement released April 3, European Union officials are holding off on loosening the equivalent standard, estimating the impact of other relief measures before taking further action. I believe in requiring banks to comply with the CECL but providing some form of capital relief. 

My message also echoes that of Kathleen Casey, chair of the Financial Accounting Foundation’s board of trustees, which oversees FASB. She wrote a letter to congressional leaders arguing, “Those who have raised objections to the implementation of the standard are primarily concerned about the effect it has for some banks on their regulatory capital. This concern can be addressed directly by the regulators themselves without requiring any change to CECL or its effective dates.” Stated differently, regulators can always choose how to implement the appropriate level of capital requirements in light of the information the CECL produces. Our research suggests that if banks implement the standard, regulators will optimally use balance-sheet information to tailor banks’ capital requirements to the riskiness of banks’ loan portfolios. In doing so, regulators could relax capital requirements to spur lending. 

As the crisis evolves, many companies and consumers will unfortunately default on their loans, and banks will incur credit losses. But banks that are timely about recognizing these losses will emerge from this crisis in better shape and with more credibility. For regulators, the crisis underscores the importance of adjusting regulatory capital to the CECL. The sooner regulators act, the better-prepared banks will be for weathering further crises. 

Haresh Sapra is the Charles T. Horngren Professor of Accounting at Chicago Booth.