Forbearance during coronavirus a double-edged sword

The coronavirus rescue package included a provision that allows banks to engage in loan forbearance without having to designate the loan as a troubled-debt restructuring for accounting purposes.

This form of relief for banks has a sad history, and its current application has debatable merits. Congress should allow the relief to expire at year-end, and the federal banking agencies should not reinstitute it through regulation or guidance.

Under the coronavirus relief bill, financial institutions do not have to classify a loan modification to a help a struggling borrower as a troubled-debt restructuring (TDR) and hence treat the loan as impaired when setting the allowance for credit losses.

The relief covers forbearance actions taken before the end of 2020, or 60 days after the national emergency declaration is lifted by the president. The relief extends for the duration of the loan. The federal banking agencies are required to allow financial institutions to determine whether to make the modification and not treat the loan as a TDR.

The motivation of Congress was clear, understandable and commendable: to prevent the bank examiners and accountants from criticizing banks for taking actions the government was simultaneously encouraging the banks to take. That is, offering relief to borrowers experiencing difficulty as result of the pandemic.

The policy seemed sound at a time when the pandemic appeared temporary, with affected businesses and households snapping back to performing status.

That said, “forbearance” has long been a dirty word in the bank examination context. And history, both in the U.S. and abroad, has demonstrated that forbearance from a supervisory perspective generally is poor policy.

Here the classic case was the 1980s savings and loan crisis, when the thrift regulator (the Federal Home Loan Bank Board) allowed insolvent thrifts to continue paying up for deposits in order to grow their way out of their problems.

By contrast, the decision of U.S. banking agencies not to engage in forbearance during the global financial crisis a decade ago was one of the wisest decisions made, and a major reason the surviving U.S. banks emerged from the crisis in a position of strength.

Elsewhere, Japanese forbearance measures have been viewed for decades as a cautionary tale. And in Europe, a lack of bank resolutions or consolidations after the financial crisis is often seen as a cause of the 2012 sovereign debt crisis.

Furthermore, the troubled-debt restructuring relief offered to banks is being conducted under the cloak of examination secrecy. While the financial regulators are tracking each bank’s use of the relief, they are not disclosing those numbers. Thus, bank balance sheets may become increasingly difficult for policymakers, investors and the broader public to understand.

Contrast this action with another type of forbearance: the banking agencies’ decision to delay the capital impact of the new accounting standard for setting a bank’s allowance, the current expected credit losses standard, or CECL. While the capital impact is delayed, banks will nonetheless continue to report their earnings under the accounting rule and manage their reserves appropriately.

Thus, any analyst can determine precisely what impact the agencies’ forbearance has had on the regulatory capital ratios of any publicly traded bank subject to the rule. A similar approach on TDRs would have been possible.

For many U.S. banks, though, the effects of TDR forbearance have been mitigated. As noted, under CECL, a public company must still set its loan-loss allowance independently of the TDR relief, based on the expected life-of-loan losses.

For the 34 largest U.S. banks that are subject to the Federal Reserve’s annual stress testing regime, there is no TDR relief granted in determining what the stress losses will be.

For the nine banks subject to the advanced (models-based) approaches to risk-based capital, those risk weights are rising independently of the corresponding loans’ status as TDRs. Lastly, larger publicly traded banks may choose to disclose data on their loan forbearance.

For the rest, all the bills for loans being deferred as a forbearance measure are likely to come due in early 2021, when further forbearance arrangements or modifications are no longer entitled to TDR relief. The FDIC may then have many insolvent banks to resolve, likely at higher costs than if their problems had been recognized earlier. Meanwhile, the value of branch networks in resolution may have diminished, further complicating resolutions.

There is a potentially worse outcome, however. One of the great lessons about regulatory forbearance is that once it starts, it’s really hard to stop. So, if the economy struggles, don’t be surprised to see strong pressure for an extension of the relief.

But any need for an extension would be the best argument against granting it. The initial premise of the coronavirus relief was that businesses were experiencing short-term problems ahead of a V-shaped recovery. If relief is still necessary 10 months later, that premise was clearly wrong.