By Karen Shaw Petrou
On April 13, federal banking agencies released their plan to require regulatory-capital recognition of the FASB’s new current expected credit loss (CECL) accounting method. Doesn’t it sound technical, dull, and irrelevant to economic equality? The integration of capital regulation with CECL is indeed technical and often dull, but it’s absolutely critical to the ability of U.S. banks to make the long-term, higher-risk loans essential for reversing at least some U.S. income and wealth inequality.
CECL accounting can and should guide loan-loss reserving and capital regulation should then reflect the added safeguard provided by these larger loan-loss reserves. However, double counting reserves and capital pushes vulnerable borrowers still farther from sustainable lending from regulated institutions and thus puts them at still more of an income and wealth disadvantage. We’ll have very, very safe banks, but also a very, very unequal economy.
Why? Bear with me for a bit of technical dullness. One of the problems uncovered at considerable cost in the crisis was the fact that the then-applicable way banks and other lenders established their loan-loss reserves was the “incurred-loss” methodology. Designed to prevent companies from keeping the “cookie jar,” as a former Freddie Mac executive famously said that he had on hand to manage his earnings, incurred-loss reserve accounting required financial institutions to put aside reserves when losses materialized, not when they might be expected due to the nature of the loan or the economy in which the loan is made. When losses deluged the banks, reserves were wiped out almost overnight and banks were forced to use their capital and – when that wasn’t nearly enough – to fail.
The CECL methodology cures for this – and rightly so – by requiring lenders to set aside loan-loss reserves based on what might happen to each loan over its life based in part on robust projections of broader macroeconomic factors. Loan-loss reserves are thus a far more meaningful bulwark against economic downturns and of course that’s all to the good. Or at least it is in theory.
The practical problem here is that bank regulatory capital is also supposed to provide a bulwark against credit risk – that’s why all of the post-crisis capital rules are so demanding. While in theory loan-loss reserves are for expected loss and capital is the backstop taking the hit for unexpected loss, the post-crisis stress tests totally blur this distinction.
CCAR’s baseline scenario is based on expected loss and then the increasingly stringent ones ramp this up in ways directly analogous to the loss projections required under the CECL method. With both CECL and CCAR, banks are thus double-charged for credit risk – once in the reserve bucket and then again in the capital account.
Two cases show why economic equality suffers when banks are so bulked up with both reserves and capital: mortgages and small-business lending.
First, CECL is likely to hurt bank mortgage lending because mortgages are long-term assets. Another feature of this accounting methodology is that, while lenders must immediately reflect potential losses over the life of a loan, they can only recognize income as the loan is paid off. The longer the loan term, the slower this pay-back and thus the more costly the upfront reserve. This is a problem for all mortgage lenders but add in punitive capital requirements and banks are double-whammied.
It’s hard to see banks doing more than making short-term ARMs to jumbo borrowers. They’ll hold lots of agency RMBS – little expected credit loss there due to the federal guarantee – but then hopes for any private mortgage market to reduce taxpayer exposure are doomed.
Small-business lending? A lot of small-business lending comes through second mortgages or HELOCs backed by housing collateral. See above for what happens to mortgages. Credit-card loans are also a major source of small-business finance, but are open-end extensions of credit and thus subject to particularly pessimistic long-term loss projections. Securitized credit-card receivables that shed the loss could ease this pain. Still, at least some card lending to small businesses will suffer.
What about direct lending for small-business start-ups and ongoing operations? Small banks are more important here than big banks so CCAR counts far less against this type of lending. Or it would if CECL didn’t also apply to small banks and thus force them also to ramp up loan-loss reserves and regulatory capital for all but the safest, shortest-term, and best-secured small business loans (assuming they can find any that meet these demanding criteria).
In the NPR, the federal banking agencies seem to have an inkling about how much damage they might do. They thus say that, if CECL in concert with capital reductions causes problems, they’ll think about a fix. The hard lesson of already-scant supplies of equality-enhancing mortgages and small-business lending is that later will be way too late.
Repairing the way CECL-set reserves intersect with regulatory capital is technical. The proposal doing so will surely be dull. However, the potential for equality harm is so compelling that we need to rip off our green eyeshades and get the agencies quickly to count loan-loss reserves as capital.