CECL is a real threat to the financial system

As someone committed to a wide range of progressive causes, I’ve never been afraid to stand behind tough financial regulations — even when my friends in finance have objected.

A quarter-century ago, I spearheaded a campaign to compel banks to lend more generously in marginalized communities, and then to put bankers who failed to heed fair lending laws in regulatory crosshairs. But as the nation has learned from regulatory history, well-intentioned reforms can damage the very economy they seek to protect. Today, that is a worrisome possibility once again.

This month, the Financial Accounting Standards Board is beginning to mandate changes to the way financial firms report Current Expected Credit Losses, or CECL.

The changes are designed to enhance accounting transparency — to ensure anyone looking at any given bank’s books can glean an accurate snapshot of its financial health. Unfortunately, these changes will both undermine the financial industry’s ability to work itself out of a crisis and discourage lending to small businesses.

To appreciate the new threat, it’s important to first understand the underlying circumstances.

Banks are in the business of taking calculated risks. Regulators, driven to enhance each lender’s safety and soundness, have long encouraged every bank to maintain a rainy-day fund. This is a special reserve designated as a bank’s Allowance for Loan and Lease Losses, or ALLL.

Concerned that an ALLL somehow masked a bank’s financial results — even though it’s completely transparent — the FASB decided years ago to impose standards limiting how much banks can set aside as a cushion for the inevitable rainy day.

The effect during the Great Recession was predictable. When the housing bubble burst, many banks did not have sufficient reserves to cover failed loans. Had banks had larger ALLLs (had they been permitted to set more money aside) they would have been better equipped to weather the storm.

Perhaps more confounding, the incumbent rules induced banks to raise additional reserves for new loans in the midst of the crisis, making it harder to lend to struggling businesses at the same time that regulators were encouraging them to add liquidity to the economy.

More recently, the FASB endeavored to reform the rules through CECL explicitly to correct for these problems. But even if considered in the most charitable light, the changes are suboptimal at best.

In good times, the FASB is now encouraging banks to use modeling standards that require financial institutions to put funding aside in amounts that are often far beyond what the banks themselves deem appropriate for their least risky loans. This creates a perverse incentive for bankers to understate the chance that riskier loans will fail.

Moreover, even if modeling can be an efficacious method of measuring risk, bank regulators should make that decision; not accountants. Likewise, if regulators believe bankers should have more latitude in putting additional funds into their ALLLs — as they do, on the whole — accountants shouldn’t stand in their way.

CECL also threatens to undermine the financial system during bad times. At the sign of a downturn, banks are now required to contribute more to their ALLLs.

One study found that, had the new CECL standards been in place in 2007, the Great Recession would have been more acute. Another analysis concluded that, in the event of the next recession, banks would be compelled to pare back lending to consumers in a pinch.

What’s worse, the new rules are particularly disadvantageous for the smaller community banks that provide a disproportionate share of lending to small businesses and rural communities.

Community banks simply don’t have the margins to accommodate CECL’s mandated reserve requirements and compliance costs. Moreover, the new accounting rules fail to account for the fact that community bankers often make judgments based on personal relationships and deep familiarity with their clients.

As a result, community banks will immediately have to set money aside for loans with minimal to nonexistent risk. And because CECL is formula driven, bankers that take riskier bets may put less away than their portfolios might otherwise require.

For many Americans, the distinction between accounting and regulatory standards may seem at best mundane, and at worst inscrutable. The modern economy depends on the accounting industry’s high standards when parsing financial reality. But the job of maintaining safety and soundness should be left to the agencies assigned that particular responsibility.

So long as banks remain thoroughly transparent about how they comply with safety and soundness guidelines, it should be up to a bank’s regulator — not an accounting industry group — to determine how banks comply.