In finance, accounting is everything.
Accounting for everything, especially when it comes to credit — in other words, taking stock and measure of where lending activities have been concentrated, where risk is and where losses may loom — is as much art as science.
For lenders large and small, a new accounting rule could start to tighten lending standards, with the ripple effect of perhaps making credit a bit scarcer.
CECL stands for “Current Expected Credit Losses” and replaces the Allowance for Loan and Lease Losses accounting standard.
Broadly speaking, amid higher allowances, banks would charge higher rates amid higher risk.
We’ve seen the first shots across the proverbial bow, as big banks such as Citi, Wells Fargo and JPMorgan Chase reported how CECL adoption has impacted results — and what they can expect going forward.
One standout, and germane to payments: the allowance for credit losses that are estimated for credit cards increased across several big players in financial services.
These are not only the concerns of big banks. CECL dawned for those larger public firms this year, but will take effect for smaller, private banks and credit unions beginning in 2023.
Drilling down into the numbers a bit, JPMorgan said CECL will bring its credit loss allowance 30 percent higher, by about $4.3 billion, to more than $18 billion. Within that tally, allowances for credit cards have almost doubled, rising by $5.5 billion, and overall, taking into effect cards and other consumer loans that impact comes to $5.7 billion. CFO Jennifer Piepszak said on the conference call with analysts, “I think it’s fair to say under CECL you could have incremental volatility given that reserves are more dependent on specific macro economic forecasts. But that would depend of course on our ability to have foresight into the timing and extent of those downturns. In cards specifically … in any one period of growth or downturns you could see an increase in reserve and expense that we’re taking.”
Separately, Citi said CECL has resulted in an expected increase to card loss estimates of about 28 percent, up by $4 billion. The list goes on, as Discover has said the new accounting rule would boost loan loss reserves by about $2.5 billon, American Express by $2.7 billion.
“We expect loan loss provision volatility to increase,” Morgan Stanley said in a note cited by CFO Dive. “This drives up cost to originate new loans, especially for the lower credit quality borrowers to whom many retail card portfolios skew.” The analysts have pointed to Macy’s and Kohl’s as being vulnerable to a slowdown in credit, which would negatively impact their in-house card operations.
Peeking Under the CECL Hood
To get a sense of some of the mechanics of how it all works: Capital One increased its allowance by $2.9 billion, and CFO Scott Blackley offered a bit of a peek under the hood in the company’s latest conference call.
In remarks to analysts, he noted that “we start with a 12-month loss outlook which we forecast. We then extend that into a lifetime forecast and when we do that we assume a gradual reversion of losses to historical averages after that first year. And then we overlay that with future recoveries and future recoveries are a big offset to our CECL allowance.”
He noted that before the implementation of CECL, the company offset its allowance with expected recoveries for only the ensuing 12 months.
CECL traces its roots back to 2012, and the aftermath of the Great Recession, when banks and other lenders did not recognize or reserve against loan losses as they faced economic downturns. In years past, lenders set up reserves for losses when borrowers put a brake on making payments. The CECL implementation is anticipatory, rather than reactive — requiring estimates (guesstimates, perhaps) as to what losses may be right when the loans are extended to borrowers.
And it should be noted that the reserves are meant to shore up capital, which banks need during downturns. Yet the higher the reserves, the less credit is made available. That could be especially troublesome for retailers which also issue cards and are reporting under CECL’s rules.
In other words, accounting changes could conceivably (eventually) translate into a very real change in the ways companies extend credit — and to whom.