A $46 billion bad-loan mirage hints at flaw in U.S. bank rule

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An early warning system for bad bank loans is taking effect this year. Beware false alarms.

U.S. banks are starting to book provisions for potential loan losses under a new system regulators devised eight years ago to avoid the kind of catastrophic surprise that caught the industry and regulators off guard during the financial crisis. The idea is to force banks to boost reserves based on models that factor in the economy, rather than wait for loan payments to stop.

But mighty swings in estimated loan losses in recent years show how the system also has the potential to raise concerns prematurely or to even send mixed signals. When the rule, known in the industry as CECL, was initially written in 2012, regulators and analysts estimated the provision increase for the four largest U.S. banks would be $56 billion. Last week, banks said it's a mere $10 billion.

That $46 billion gap at JPMorgan Chase, Bank of America, Citigroup and Wells Fargo shows how economic shifts and the lenders' assumptions can have a significant impact on estimates — a level of discretion that could allow executives to delay higher reserves or set off a surge in provisions if they are too conservative heading into the next economic slump. It's also possible assumptions will diverge among firms, leading to confusion.

"We expect higher volatility in provisions under the new rule," Maria Mazilu, an accounting analyst at Moody's Investors Service, said in an interview. "We will only find out how good the models at predicting losses are in the next downturn though."

The rule was prompted by widespread criticism of global banks for being too slow to recognize potential loan losses heading into the 2008 crisis. It's meant to alert shareholders earlier to any brewing trouble by essentially amplifying expected loan losses based on the stages of the economic cycle.

When it was first proposed, the U.S. was still climbing out of the worst recession since the Great Depression, and projections were grim. Banks have reshaped their lending books over the years. And today, after a long run of economic growth, few in finance are expecting a downturn soon, leaving reserves far lower. Yet all that could change anew when the economy starts heading south.

The old rule allowed less discretion: Banks set aside provisions when borrowers stopped making payments. The new rule requires lenders to model losses from the day a loan is made. Because that standard gives so much more discretion to banks' internal models, it will decrease comparability among peers, Moody's has warned.

But if the rule works as envisioned, big banks will head into the next bout of turmoil with larger loan-loss reserves — a buffer in addition to their underlying capital, which has also been increased by post-crisis regulations.

Some relief

Bank regulators gave firms up to four years to absorb the initial impact on their capital from the accounting rule change. But regulators stopped short of reducing capital requirements to balance out the jump in reserves. That means when reserves do rise further on the risk of a downturn, big banks would need to replenish capital eroded by the hit to earnings.

"If you're not overcapitalized, then CECL's impact on reserves will be higher capital," said Warren Kornfeld, an analyst at Moody's covering consumer finance companies. "Reserves will go up by x, but capital won't be allowed to go down by x."

JPMorgan, Bank of America and Citigroup noted while posting earnings last week that initial implementation will reduce their capital by about 0.2 percentage points.

Wells Fargo lowered its loan-loss provisions because the new rule allowed the bank to write up the value of some collateral backing soured loans. The company didn't say how much positive impact the reduction would have on its capital.

Smaller banks also have expressed concern about the volatility CECL may cause. And because they lack resources to handle projections internally, some have noted the risk of relying on models and economic forecasts from third parties, such as Moody's. Community banks and credit unions were given a reprieve last year when their deadline for compliance was extended to 2023. But midsize banks like Wintrust Financial Corp., Illinois's biggest publicly traded bank, weren't included.

"CECL is going to be all over the board on this," that bank's chief executive, Ed Wehmer, said on his company's earnings call this week. "And if the guy at Moody's has a bad day or a hangover or his hemorrhoids act up, he could take the banking business down because everybody's basically using Moody's baseline as their basis for this."

Bloomberg News
CECL JPMorgan Chase Bank of America Citigroup Wells Fargo