[UPDATE: January 13, 2020]
Lenders are bracing for the impact of a change to the way they have to account for losses on loans. The new “current expected credit loss” (or CECL) standard—described in detail within our original alert article below—became effective in 2020 for publicly-traded banks.
The change has certainly created work for accounting departments. And as a recent Wall Street Journal article indicates, additional fallout is expected as well. First, it could create a “noisy” earnings season for lenders in the first quarter of 2020. As lenders adjust their reserves upward to meet CECL requirements, their earnings could be impacted. Second, because loss estimates (and as a consequence, reserves) will be adjusted on an ongoing basis, the volatility of reserves could increase under the new rule.
Third and finally, the Wall Street Journal flags a particular worry for consumer lenders. A decade removed from the last recession, lenders have been extending the duration of relatively risky consumer loans, like auto loans. That enhances the impact of CECL on consumer lenders, which investors may already be anticipating. As of the new year, consumer-lending banks were trading at 8.6 times forward earnings, markedly less than their five-year average of 9.9 times. Banks in the S&P 500, by contrast, were trading at 12.1 times, a premium on their five-year average of 11.5.
Atalaya will continue to actively monitor this development and work with our range of counterparties to provide capital solutions where helpful.
For this Regulatory Alert, we focus on a new set of accounting rules for bank reporting of losses on loans. The new standard, Financial Accounting Standards Board’s (FASB) Current Expected Credit Loss (CECL) model applies to all banks, savings associations, credit unions and financial institution holding companies, regardless of asset size. The timeline for implementation in public institutions is different from that of private institutions: publicly-traded banks will need to integrate CECL at the start of 2020, while private institutions will have until the end of 2021.
The current GAAP standard — an incurred loss model — requires financial institutions to recognize losses at the time when there is no longer an assumption that future cash flows will be collected under the contracted terms. CECL will require institutions to use historical data to forecast expected loss over the life of the loan and do so at origination or purchase. The CECL standard changes the current accounting standard in two primary ways:
1) It prevents the delayed recognition of pre-financial crisis loan losses and
2) It requires the analysis of a broader range of data to predict loss behavior.
CECL does not change the existing write-off principle in GAAP, nor does it impact the current accounting requirements for loans held for sale. Still, according to research from Keefe, Bruyette & Woods ("KBW”)1, it is expected that CECL will result in larger loan-loss reserve allowances for most financial lending businesses, with the median company seeing a 36% increase in their allowance. KBW also estimates that for the median company, the provisioning expense will increase by approximately 7% in 2020 using CECL vs. the current GAAP accounting standard.
The impact will vary by asset class, with the consumer finance sector appearing especially susceptible according to KBW. Additionally, depending on the strength of the bank and credit conditions, the impact could vary significantly. For banks that have built reserves for lifetime losses and can cover expected losses with existing balances, CECL may not result in a significant increase of provisioning on earnings. For lenders and lessors who must adopt CECL, the integration process and uncertainties around provisioning can be overwhelming.
Atalaya Leasing has flexible capital to provide solutions to a broad range of lease counterparties, including originators, vendors, banks and traditional lenders. As CECL could prompt earnings volatility for some counterparties, we may have the opportunity to be helpful and are actively monitoring this development.
1“CECL’s Impact on the Financial Industry”, KBW Spotlight dated June 16, 2019.