Nonbank players are ready for CECL — are banks?
As debates rage over the incoming current expected credit loss standard, it has achieved the rarest of feats in today’s political environment: bipartisan accord, however dubious it may be.
Lawmakers from both sides of the aisle have expressed concerns about the unintended consequences of the new standard on financial institutions, consumers and the economy as a whole. These concerns have merit, as some of the externalities stemming from the standard may prove unpalatable for certain market participants.
The initial intent of the CECL guidelines was to make loan-loss allowances more reactive to the credit environment. By setting aside greater allowances, organizations would be better prepared for a default.
This is a laudable goal and research in this area seems to indicate that CECL rules would have ameliorated the overextension of credit that led to the last recession.
However, the unintended effects of CECL are becoming more apparent. For example, it is clear that significant allowance volatility will be a hallmark of CECL implementation.
Earnings calls at major banks have indicated that the projected one-time impact of CECL at adoption will be all over the map. Some institutions estimated increases to their reserves of 30% to 40%, while others projected a reduction in reserves.
Allowance volatility feeds into earnings and is therefore a significant driver of volatility to general earnings.
And volatility matters. Past literature suggests income volatility is associated with discounted market valuation.
In fact, a recent Moody’s Analytics study found that the market discounts allowance volatility in particular, with every 1% increase associated with a 6-basis-point decrease in equity share value. This effect will be even more pronounced in the next economic downturn.
To minimize earnings and allowance volatility, and to offset operational costs, we expect banks to become more reactive to early warning indicators and increase rates on longer-dated assets; or pull out of certain deteriorating lending segments.
Banks will make this choice, especially once deterioration in the credit environment initiates a reactive increase in allowance.
Because banks are designed to react to a deterioration in the credit environment, forward-looking CECL measures naturally lend themselves to robust credit portfolio management.
The upfront logistical challenges and costs of adopting these measures in portfolio management will be considerable but the benefits are now becoming apparent.
The measures can be used to improve lending standards. And when applied toward credit portfolio diversification, it can minimize concentrated exposure to common factors that will manifest in material swings in expected credit losses.
As a corollary, the effects of banks reacting in this way will be felt most acutely by segments whose credit quality deteriorates in the next credit downturn, and who will see their access to credit shrink.
But nature abhors a vacuum. And as traditional financial firms pull back to modulate CECL’s effects on their business, new securities and nontraditional lenders that can ostensibly manage these dynamics better will move in to fill the space vacated by conventional lenders and products.
Others have already entered the space like LendingClub and LendIt that are able to penetrate areas underserved by traditional banks.
While CECL has the potential effect of exacerbating underserved loan markets in the short run, it can accelerate the entry of new players, allowing for a long-term equilibrium with a more stable banking sector and more comprehensive credit market coverage.
However, there are many unknowns that need to be monitored and considered by policymakers.
Programs designed to bolster the functioning of credit markets in underserved segments — like those of the Small Business Administration and Federal Housing Finance Agency — will need to be reassessed and perhaps, reinforced as the market works through the transition.
The recently announced delay to CECL’s implementation for some institutions should serve as a welcome reprieve for affected stakeholders, but the impact of the new rules on credit markets will be felt with the immediate deadline that is faced by the broader market.