CECL Will Result in a Sizable Capital Hit for U.S. Banks

While a new reserve methodology is far from popular among U.S. banks, it could prepare them for the next economic downturn.

The banking industry has bemoaned the new provision largely due to its complexity. The current expected credit loss model, or CECL, will require banks to set aside reserves for lifetime expected losses on the day of loan origination, resulting in a sizable hit to capital at adoption.

S&P Global Market Intelligence has developed a scenario estimating CECL’s capital impact to the banking industry in aggregate as well as community banks — institutions with less than $10 billion in assets. The upfront reserve build that will come with CECL adoption could allow banks to better withstand a downturn, which could begin when banks adopt the methodology in 2020.

But, we don’t expect banks to take the change in stride and believe institutions will respond with higher loan prices and slower balance sheet expansion.

CECL becomes effective for many institutions in 2020 and will mark a considerable shift in practice. Banks currently set aside reserves over time, whereas the new provision requires them to substantially increase their allowance for loan losses on the date of adoption.

Given the capital hit, S&P Global Market Intelligence believes the industry’s tangible equity-to-tangible assets ratio could fall to 8.25 percent in 2020, assuming uniform adoption of CECL by all banking subsidiaries at that time. That level is 127 basis points below the projected capital if banks continue operating under the existing incurred loss model.

We expect a much more manageable capital hit for community banks, which could see their tangible-equity-to-tangible assets ratio fall to 11.13 percent in 2020, 50 basis points below the projected capital level for those institutions if they maintained the existing incurred loss model.

We assume that CECL reserves would match charge-offs over the life of loans. For the banking industry, we assumed the loan portfolio had an average life of three and half years, while assuming an average life of four and half years for community banks, based on the current loan composition of both groups of institutions.

The expected level of charge-offs stems from our longer-term outlook for credit quality. While improving sentiment among consumers and businesses should support relatively strong asset quality in 2018, credit standards should begin to slip in 2019 as banks compete more aggressively to win new business. Competition should increase because economic growth is not expected to be quite strong enough to create sufficient opportunities for banks to lever the additional capital created by tax reform.

Changes in the competitive environment could coincide with regulatory relief efforts. The Trump administration and Republican-controlled Congress have pushed to soften many rules passed in the aftermath of the credit crisis and the rolling back of regulations could invite further easing of underwriting standards. This would occur as interest rates increase, leading to a more expensive debt service and pushing some borrowers to the brink.

Even with those headwinds, community banks should once again maintain stronger credit quality than their larger counterparts. Community banks have greater exposure to real estate and while valuations have risen considerably since the depths of the credit crisis, there are reasons to believe smaller institutions’ credit quality will hold up far better through the next downturn.

The lack of a housing bubble and massive overbuilding in the residential real estate sector as well as heightened regulatory scrutiny over elevated commercial real estate lending concentrations should help prevent history from repeating itself.

The impact of CECL should also encourage banks to raise rates on newly-originated loans, particularly longer-dated real estate credits that will require a larger reserve build under the provision. We think that loan growth will be slower than it would have otherwise been as banks with thinner capital ratios hoard cash and work to rebuild their capital bases.

If the credit cycle bottoms several years after CECL’s adoption, the new accounting provision might work as intended. Banks will have set aside considerable reserves well ahead of a downturn and pull forward losses, meaning their earnings will be stronger when credit quality reaches a low point.

However, if losses peak as the industry implements the new reserving methodology, the hit to capital could prove even more severe and leave banks on weaker ground to weather a downturn.