The crisis should not delay stricter accounting rules

May 07, 2020

After the financial crisis, new rules were created to determine how banks recognize their loan losses. The CARES Act gave US banks the option to delay implementation of those rules. Chicago Booth’s Haresh Sapra says delaying is a bad idea—but that implementation should be accompanied by a reevaluation of capital requirements.

Video Transcript

As a result of the financial crisis, one of the biggest changes that has been brought about in terms of accounting standards is the way that banks recognize losses on their loan portfolios.

What happened is, before the financial crisis, a lot of the banks were viewed to be very slow in recognizing losses on their loans, even though they knew about the losses. They were very slow to react and recognize them on their financial statements. They used what is called an incurred-loss model. So they did not recognize the losses until the losses had been incurred or were highly probable. And this was viewed as a bad thing because banks were not very proactive in recognizing these losses, and they kept lending before the financial crisis until it was too late.

As a result of that, when the financial crisis hit in 2007-2009, most banks stopped lending because they had to write off these loans. So as a result of that, the accounting standards for recognizing losses changed, and they got replaced by a model called the expected-loss model.

This is both sides of the Atlantic. The International Accounting Standards Board and the Financial Accounting Standards Board in the US both changed the way that banks recognize losses. These rules were debated for a long period of time, and finally, these rules were put in place in 2016. 

Then they kept getting delayed and delayed. And finally, in 2018, all banks—all companies for that matter—outside the United States were required to recognize the expected-loss model, while for the US banks, these new standards came into force at the beginning of this year, 2020. 

Now, everything was going well until, of course, the coronavirus hit. And now once the coronavirus hit, many banks started complaining and saying that this is not the right time to implement these standards.

Why? Because, first of all, these uncertainties caused by the virus will result in a lot of losses that we will have to write off loans. These loans will hit our capital, and hitting our capital actually would hinder lending in the economy.

In light of all the pushback by the banks and the companies about this expected-loss model, what happened is, interestingly, as part of the CARES Act—which President Trump signed recently, in March 27 of this year—included in that CARES Act is one short paragraph. This is an 880-page document. I believe it’s on page 538 of that document. Included in there is one paragraph about delaying, allowing banks to delay implementation of this expected-loss model.

Now, that’s called CECL in the United States, the Current Expected Credit Loss model. That’s the name of the standard. So, President Trump signed this into law allowing banks to delay implementation of this, of CECL, up to the end of this year, 2020, or when the coronavirus ends, whichever comes earlier.

Now, that itself I don’t think is a good thing because this standard has been debated at length, and banks have started already implementing these standards. I don’t think delaying is a good idea here because, in my mind, this is precisely the time when banks need to be monitoring the risks of borrowers.

The idea is that the government is sending all this money to borrowers, to companies, to try to invest, and this is precisely the time where banks need to be figuring out whom to lend money to—to companies that really need it because they’re struggling, or are they lending into companies that will struggle, regardless of the coronavirus?

And this is precisely what the expected-loss models do. Why do they do that? The idea is that you are monitoring risk very carefully, and you’re using this risk model to write down your loans. So, you’re being very proactive.

This is precisely the time when there’s a lot of uncertainty in the economy, that board members, executives, managers, need to get this information so that they can make sound and efficient decisions. Delaying it is not going to be a good idea.

Now, interestingly, the Federal Reserve Bank is not doing that. What they’re saying is, if companies or banks continue to use CECL, what we’ll do is, we’ll give them capital relief.

Now that’s a good idea. Why? Because if you monitor your risk very carefully, you will relax the capital requirements, and that would spur lending.

So this is getting the best of both worlds in a way. 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.

So that’s a move in a good direction. But keep in mind, banks have a choice here. Either they delay CECL, don’t get the capital relief, or they continue using CECL, and get capital reliefs. And the latter, in my mind, is a very good idea.

In fact, this is consistent with something that I’m doing in my research. We show using an economic model that regulators, banking regulators and accounting standards-setters, need to harmonize their regulation. In other words, if you require banks to use 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.

So, this is a move in the right direction, the idea being that you use CECL, and we’ll relax the capital requirements.