A controversial proposal to change the way banks tally how much to set aside for bad loans is nearing completion, and critics are turning up the volume.
Accountants, investors and bank lobbyists are voicing their opposition to the Financial Accounting Standards Board's plan to require banks to estimate future losses on all loans they make. After years of debate, the rulemaking process has entered the homestretch, and the standards board said it plans to issue a rule by yearend.
The proposed rule would require banks to provision for projected losses over the lifetime of a loan on the day they book it, instead of the current practice of adding to provisions only when losses start to accrue. Critics say estimating losses is speculative and impractical, especially for community banks with limited resources.
The opposition is coming not just from the banking industry, which has stood against the rule from the start, but from inside the FASB itself. Two of its seven board members have committed to vote against the rule change, and more than half the members of the FASB's own Investor Advisory Committee say the model needs to be revised.
Last week Joseph Longino, a former principal of Sandler O'Neill who served on a separate FASB advisory body, wrote in a note published by Sandler that the proposal "is symptomatic of the fact that [FASB's] board has lost sight of its job description."
"The board's proposal for measuring credit risk is not accounting guidance, nor is it capable of producing financial statements worthy of the name," Longino wrote.
This opposition, however, appears to be heading for defeat. While it is unusual for two members of the standards board to publicize their plan to vote against a proposed rule, four of the seven board members would have to vote against it to block the change.
A FASB representative said the group expects to approve the rule before the end of the year.
"The FASB staff currently is drafting the final standard on impairment, which will be discussed by the board during a public meeting in the coming months," FASB spokeswoman Christine Klimek wrote in an email. "At that meeting, the board is expected to vote to approve the standard, which we expect to issue by the end of 2015."
That meeting could mark the end of a reform debate that has gone on since at least 2012, when the standards board released a draft of the new rule. The FASB has also scheduled a private meeting for Wednesday where about 20 representatives of banks, regulatory agencies and accountancies will have a chance to discuss the rule with the accounting board's staff.
Regulators have been the most influential supporters of the proposal, arguing that it will lead to more prudent provisioning. Currently banks add to their loan-loss provisions only when losses begin, which causes low reserves in good times and a sudden buildup when a crisis hits. The latter is what happened in 2007 and 2008, and it puts additional pressure on capital and earnings during such times of stress.
Comptroller of the Currency Thomas Curry argued along these lines in a 2013 speech that criticized the current provisioning method.
"By requiring banks to wait for an 'incurred' loss event to recognize the resulting impairment, the model precludes banks from taking appropriate provisions for emerging risks that the bank can reasonably anticipate to occur," he said.
The FASB's new approach aims to solve that problem by requiring banks at the outset to establish provisions based on the estimated loss rates over the entire life of the loan.
Opponents point out that this solution would open up a new set of problems, chiefly the infeasibility of making accurate loss projections decades into the future.
Mike Gullette, vice president of accounting and financial management for the American Bankers Association, said he has no problem with estimating losses but thinks there needs to be a clearer time horizon. "Nobody has a clue" how to forecast loan losses 30 years into the future, and community banks especially lack the resources to do so, he said.
"Community banks will just be overwhelmed by the data that's going to be required to be maintained and monitored," he said.
Gullette also argues that the estimated-loss approach - intended in part to smooth out earnings -- would actually create more volatility, because banks would have to recalculate their expected losses every time the economic outlook changed.
Longino argued that this volatility would sow confusion.
"[T]he implication that investors would wish upon themselves the speculative recognition of lifetime credit risk in the financial statements confounds belief, as does the implication that investors would wish upon banks and other entities gratuitous volatility in their financial statements," he wrote.
Investors are indeed concerned. The FASB's Investor Advisory Committee wrote in April, in a letter to the group's board, that "a majority [of the committee] view the proposed model as needing improvements" on several points. Among these are technical issues related to M&A accounting and a lack of clarity on how to calculate expected losses.
Though nearly six months, and several meetings between the FASB and its investor committee, have passed since that letter was written, "many of the topics and issues that have been raised by the [committee] still appear to be areas of concern," said committee member Joe Stieven of Stieven Capital Advisors.
The final rule might be tweaked at the upcoming FASB meetings, but even the rule's opponents regard the estimated-loss model as more or less a fait accompli. They are hoping for minor concessions, particularly ones for community banks.
"I'm just hoping that, at a minimum, they change the language to allow a smaller bank to have a less complex process," Gullette said.