Change Looming for Banks in Accounting for Loan Losses
Author: Jason Rader
Earnings for banks around the country have been rising for several years as the industry continues to shake off the last of the lingering credit effects from the Great Recession. According to the Federal Deposit Insurance Corporation’s Quarterly Banking Profile for the second quarter of 2016, commercial banks and savings institutions reported aggregate net income of $43.6 billion, up 1.4 percent from 2015.
The increased 2016 earnings primarily were related to increases in net interest income, driven by loan growth as interest rates remained historically low. This increase was not a surprise, as aggregate earnings for banks have been rising for the past six years since reaching the bottom of the Great Recession in 2009 to 2010. However, until two years ago, a principal driver of increased earnings was a reduction in provisions set aside for bad loans, i.e., the provision for loan losses, which reached historic levels around 2011. As banks then worked through problem loans from 2011 to 2014, the provisions set aside for additional losses shrank, which helped banks increase their earnings despite stagnant loan growth and shrinking interest margins.
Since the middle of 2014, while bank earnings have continued to rise, the increase has been primarily fueled by increased loan demand, which has helped banks maintain or grow their net interest income and other operating factors. This loan growth has resulted in modest increases in new loans’ aggregate provisions, which bankers expect to continue as their core lending businesses grow. However, another concerning factor for bankers is the Financial Accounting Standards Board’s (FASB) controversial change to accounting for credit losses in June 2016—the current expected credit loss model (CECL). This will affect banks’ timing and amount of provisions.
By today’s accounting standards, creditors, e.g., banks, operate under the incurred loss model methodology. That results in banks only accruing for losses they reasonably expect to incur based on presently known factors, i.e., probable losses incurred to date. However, many community bankers will state their reserves are partially based on the future, although those loss estimates aren’t quantified in their models.
With the 2007 economic downturn, banks began experiencing sudden unplanned loan portfolio losses. Some industry observers, including state and federal agencies that oversee banks, lamented that the model used should have been more forward-looking, allowing or requiring banks to forecast expected losses. It would have helped banks to build reserves ahead of the downturn, preparing for the significant amount of write-downs and losses. This argument is debatable, as it involves an estimate significant to any bank’s operating results.
Currently, a credit loss must be considered probable of occurring prior to establishing a reserve. A bank is required to consider past events and current conditions in measuring credit losses. With the CECL model, an entity will recognize an impairment allowance on the day a loan is recorded for its current estimate of contractual cash flows not expected to be collected. Banks will then be required to consider relevant internal and external information, including reasonable and supportable forecasting of events, in assessing the collectability of cash flows at each reporting period.
Industry trade groups, e.g., the American Bankers Association, and investors heavily weighed in on the final version of the CECL model. Most industry observers believe the CECL model is more workable for banks and other lenders than some earlier versions.
Due to significant changes required by CECL, FASB delayed the required implementation for several years: U.S. Securities and Exchange Commission filers will adopt in 2020, and other entities will adopt in 2021. However, due to the internal system changes and new required data for making an estimate consistent with CECL model requirements, banks are encouraged to begin planning for this significant accounting change now.
Contact your BKD advisor if you have questions.