Mercator Advisory Group thinks that the credit card industry benefited from the implementation of Current Expected Credit Losses (CECL), even though the transition was somewhat painful. And coincidentally, the timing was perfect.
Here is an article from Fitch Ratings that supports our position. Fitch Ratings is a top credit rating agency, often used by Wall Street to value financial assets, including credit card asset-backed securitizations.
In a rating report, Fitch notes that Canadian Banks, who provision based on International Financial Reporting Standards for loan losses (IFRS9), are less reserved than U.S. banks that follow CECL standards. (For a deep dive on CECL, see this Mercator Advisory Group Viewpoint). A key difference is the timing horizon for reserves. U.S. banks must look at lifetime losses, IFRS only looks at 12 months.
- In addition, under the IFRS9 accounting standard, Canadian banks have lower provisioning requirements for performing loans, wherein banks need the only provision for expected 12-month losses for loans with no signs of deterioration. Conversely, under the U.S. CECL accounting standard, U.S. banks are required to provision for expected lifetime losses at origination.
The difference is significant. If the financial institution is north of the U.S./Canada border (or in most of the world), and under IFRS9, credit policy people only add to their loan loss reserves for what can happen to the account for the next 12 months. South of the border, the view has to consider what economic factors can impact the account over the next 36-48 months.
One rule is not necessarily better than the other, but they are different and should be acknowledged.
Take COVID-19 as an example. The U.S. impact is far severe.
- Canadian banks may also moderately benefit from the successful containment of the coronavirus outbreak relative to the U.S. On July 30, daily confirmed COVID-19 cases per million people were just 13 in Canada, versus 227 in the U.S, according to the European CDC.
And, U.S. banks are bigger into credit cards than Canadians.
- Notwithstanding a lower starting base, Fitch expects Canadian banks to maintain a reserve gap relative to U.S. peers, reflecting differing business mixes and accounting methodologies. At 2Q, Canadian banks’ median risk-weighted assets were 35% of average assets, compared to 55% at U.S. peers, as Canadian banks generally report lower consumer loan exposures than large U.S. credit card issuers such as JP Morgan Chase and Citigroup.
Fitch’s article has a helpful chart that shows “Allowance for Loan Losses of Adjusted Gross Loans.” Here you will see U.S. banks with a median reserve of 2.37% versus Canada at .89%. Chase and Citi are the most fortified with 3.35% and 3.87%, respectively. Bank of Montreal and the National Bank of Canada are only at 0.65% and 0.73%, respectively.
The most interesting point here is the impact to profit, which makes U.S. banks appear less profitable than Canadian banks.
- While not expected, if Canadian banks were required to build reserves to similar levels as U.S. peers, they would likely lag U.S. banks in returning to pre-pandemic financial performance. A hypothetical buildup of Canadian bank reserves to 2% of adjusted loans would consume 180% of 2Q20 PPOP on average or 46% of the average PPOP of the last four quarters. Except for Wells Fargo, the large U.S. banks report consistently higher PPOP as a percentage of adjusted gross loans, exceeding the Canadian average by nearly 30bps.
The takeaway: U.S. regulators got this one right. Less profit, less risk always lets bankers sleep better.
Overview by Brian Riley, Director, Credit Advisory Service at Mercator Advisory Group