Mercator Advisory Group’s early view on Current Expected Credit Loss (CECL) was that the Financial Accounting Standards Board (FASB) would increase loan loss expenses and diminish profitability. However, the view was that CECL would also help brace the industry against financial shock in a downturn. The regulation did its job and helped the industry keep a steady ship as we navigate through the COVID Crisis.
This article from Fortune talks about some of the nuances of the accounting policy, which is in place since January 2020.
- Now, as the effects of the pandemic on consumers’ wallets begin to emerge, that rule has taken on new importance.
- The reason: The new regime requires lenders to look far into the future and book all the losses they expect on credit cards and other borrowings—over the entire life of the loans—right now.
- That new practice should give investors a much clearer window into where the consumer is headed than the old regime, which mandated estimating defaults only for borrowers who had ceased paying interest and hence furnished only a short-term picture.
- Giving a more comprehensive view of losses to come also provides one of the best road maps for where the overall economy is headed.
There are two categories: credit cards and everything else.
- Bank loans can be divided into two general categories for accounting treatment: the first for credit cards, and the second for other consumer credit such as mortgages, and for business loans.
- Before CECL, the banks took provisions based mainly on the volume of loans in their portfolios that became “noncurrent,” meaning borrowers had ceased paying interest.
- Those problem credits were labeled as “nonaccrual,” meaning that the bank had stopped recognizing revenue from the interest it was billing the borrower, but the borrower wasn’t paying.
- That traditional system was called the “incurred loss model,” meaning that banks started taking provisions on loans mainly when borrowers stopped making payments.
For non-credit cards:
- When it became clear the loan would never be repaid, the remaining principal amount went to “charge-offs” or what’s called “loan losses” in the industry that are subtracted from reserves. Put simply, provisions for future losses that increase reserves and charge-offs that lower them.
But, for credit cards:
- The provisions depended on the “roll rate” of the portfolio. As different borrowers went from 30 to 60 to 90 or more days delinquent, their loans descended from one credit bucket to the next.
- The bank booked provisions based on its estimates of which noncurrent loans in each bucket would never be repaid. The longer the loan remained delinquent, the larger the portion of the principal amount that the bank estimated wouldn’t be repaid, and the larger the provision on that loan became.
- But once the credit became 180 days delinquent, it went to charge-off status and was written off as a 100% loss. That loss was then deducted from reserves.
Given the option of “paying the piper” early or later, early is often best when dealing with losses.
- The new rule is designed to give investors and regulators a much more accurate picture, far sooner, of how bad things will get in a recession.
- In Q2, BofA and the other big banks supplied their best estimate for all of the damage they expect the pandemic to inflict going forward.
- If BofA is correct, it has already charged earnings for the bad stuff to come from the COVID-19 crisis.
As we said in our original view of CECL, New loss recognition, down to the account level, will require card issuers to deepen their portfolio analytic tools and use technologies to increase customer reconnaissance, going from a broad view measuring batch performance to a single view of the customer as a segment of one. Scoring and a vision of managing the account from acquisition to maturity is essential.
Timing is everything. Had CECL not been in effect before the COVID-19 issue, credit card issuers would have been ill-prepared for the current economic shift. With CECL, at least card issuers (and investors) are braced for an extended economic recovery.
Overview by Brian Riley, Director, Credit Advisory Service at Mercator Advisory Group
