New credit loss standard manageable for US banks, Fitch says

By Ken Tysiac

U.S. banks' reserving practices will be affected by FASB's new standard on accounting for credit losses, but the effective date gives banks adequate time for a manageable implementation, according to a Fitch Ratings analysis.

FASB issued Accounting Standards Update No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, in June. The standard requires an expected-loss approach to accounting for credit losses, replacing the previous incurred-loss model.

The standard takes effect for SEC filers for fiscal years beginning after Dec. 15, 2019; all other organizations will have an additional year for implementation. The standard requires banks to estimate credit losses over the life of certain financial assets, resulting in a timing difference for when reserves are established.

In aggregate, the transition to the new current expected credit loss (CECL) model used in the standard will result in higher reserves for credit losses, according to Fitch's analysis. If CECL were implemented today, tangible equity ratios across the U.S. banking system in aggregate would take a hit of 25 to 50 basis points, Fitch estimated.

Total loan loss reserves would increase by $50 billion to $100 billion across approximately $10 trillion worth of loans in the U.S. banking system, according to the estimate. Roughly $130 billion to $140 billion currently is held in credit reserves on those loans, said Michael Shepherd, CPA, a Fitch analyst who conducted the analysis.

Fitch's analysis used simplifying assumptions and focused on loan portfolios and loan commitments, excluding securities and financial guarantees. Fitch used regulatory data, historical average loss rates by asset type, and its own assumptions of expected loan lives and credit conversion factors.

Some banks will be better positioned than others to deal with the change, Fitch forecasted. Smaller banks may face more challenges collecting data to comply with the standard because larger banks already have had to enhance their data warehouses and data modeling capabilities to comply with other regulations, said Christopher Wolfe, Fitch's managing director for financial institutions.

"Especially for smaller banks, there probably are some additional enhancements and changes they would have to make to their reserving methodologies in terms of getting additional forecasts and future economic assumptions into your loan loss reserve models," Wolfe said.

Larger banks, Wolfe said, may face their own challenges because of the cumulative effect of numerous recent regulations. In addition to FASB's credit loss standard, the largest banks are now required to hold capital in a "GSIB buffer," undergo stress tests, and may soon have to comply with new liquidity rules.

The extra 25 to 50 basis points associated with the CECL standard are not going to cripple these large banks, but add another layer of regulatory cost that will challenge banks, Wolfe said.

"No one quite knows today what that all means," Wolfe said. "I think everyone would agree, does it mean banks are safer? The answer is clearly yes. But what does that mean in terms of how banks operate? Will they do things differently or in some ways shy away from certain types of lending?"

Some uncertainty about the standard remains because it's unclear what concerns auditors may have as they audit economic assumptions and management judgment that will be used in expected credit loss estimations. Likewise, it's uncertain how the PCAOB will view these assumptions and judgments.

"The FASB has said that depending on the sophistication or the size of the bank and the complexity of the bank that in their view, different methods could be allowed," Shepherd said. "But one of the things we were thinking about is, it's really up to the auditors and also the PCAOB what would really be the threshold they would have to meet."

The International Accounting Standards Board (IASB) issued its new credit loss standard in 2014 with IFRS 9, Financial Instruments. Although the IASB's model also moves to an expected-loss approach, it is different from FASB's model. According to Fitch's analysis, the IASB's model is operationally more complex but will result in lower reserves than FASB's model, assuming identical circumstances.

Ken Tysiac (ktysiac@aicpa.org) is a JofA editorial director.

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