Why current accounting rules could stop banks from lending

May 14, 2020

Sections Accounting Video

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The current expected credit losses accounting standard was supposed to help banks be more proactive in recognizing their loan losses after the financial crisis. But the CARES Act is allowing many banks to delay implementation of the new standard. Chicago Booth’s Haresh Sapra says that at a time when lending is crucial to keeping companies afloat, we should be careful not to repeat our past mistakes.

Video Transcript

What would happen if banks did not use CECL (the current expected credit losses accounting standard) appropriately? What has happened is they have essentially ignored the accounting standard and chose to postpone it and start implementing it at the beginning of 2021. I think this is very misguided for the economy—misguided for the economy because you’re going to hurt the real economy because this is precisely the time when banks need to be lending. 

This is the point of the CARES Act. This is money being given to banks to lend to borrowers. If we stop lending right now, this is going to really hurt the economy for a long period of time. In fact, they could be lending to the wrong types of borrowers. And then there will be huge write-offs in the future, and this takes us back to the financial crisis.

This is precisely what was happening. What was happening is banks were lending money to borrowers that were very, very poor risks. And it took a while for us to recover. So we should not make that mistake again. We should learn from the lessons of the financial crisis, and this is an opportunity.

In fact, interestingly, I would say that 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. The Dodd-Frank Act implemented stress tests, and then the banking regulators increased the capital buffers.

So the banks are not the bad guys here. But they have an opportunity to be the good guys, actually, because in being very careful in terms of helping to channel this money to the right firms, they could help and spur the real economy. So I view this as a great opportunity, but that would come at them implementing CECL appropriately. 

Companies are facing multiple challenges right now. In my mind, the biggest challenge is they are facing a cash crunch. They’re facing a cash crunch because essentially everything has been frozen in the economy. They’re losing their customers. They have to continue paying their suppliers to make sure that they maintain these relationships. So most companies right now are facing a cash crunch, but in my mind it’s temporary, and this is precisely the objective of the CARES Act.

The idea is that this is precisely the time when the government needs to essentially funnel this money to companies so that they can keep paying their suppliers and their employees, because they’re not collecting cash from their customers. Their 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, which is what we saw with toilet paper. They are essentially looking for masks and food. So some businesses are benefiting from this, but the general economy is really hurting as a result of that.

So [the focus for businesses is] getting cash from the government, and paying their employees, and gradually coming back out of this. And this is going to take time and patience, but the important thing is that banks need to keep lending to these companies so that they can keep making their payments.

And that again, as I said, requires a lot of patience. And also this is where, again, the accounting would help, because those companies that are very disciplined in their risk-taking and those banks that are properly monitoring these risks will emerge from this crisis in much better shape.