Loan loan reserves: FASB's
latest proposal ushers in renewed debate
article is an online companion to the January 2013 ABA Banking Journal cover story, "The Road Ahead." To read that
article and other online articles in the report, please click here.
By Steve Cocheo, executive editor & digital content
There's never any shortage of bank
accounting issues in play, but 2013 will see a big one come center stage. The
Financial Accounting Standards Board's late December 2012 proposal for a major
shift in approach to setting the allowance for loan and lease loss reserves
(ALLL) potentially impacts every banking company, from the smallest community
bank to the largest holding company. And, alongside center stage will be
establishing reserves for debt securities--something that has not been seen
Basics of the shift
The Exposure Draft--officially
FASB's Proposed Accounting Standards Update: Financial Instruments-Credit
Losses (Subtopic 825-15)--represents the accounting rule-setter's third
pass since 2009 at amending how banks handle the establishment of reserves. The
proposal involves a significant shift in the viewpoint on which the
calculations are based.
Currently, generally accepted
accounting principles and regulatory practice call for reserves to be set based
on "incurred losses." Under this
approach, recognition in reserves of a credit loss doesn't occur until the loss
is either probable or has actually happened and it can be reasonably estimated.
The December proposal would shift
to an "expected loss" method of
setting reserves. In full, the method is called the "current expected credit
loss" model (CECL).
Under this concept, according to
FASB, "the allowance for expected credit losses would reflect management's
current estimate of the contractual cash flows that the company does not expect to collect, based on its
assessment of credit risk as of the reporting date." [Emphasis added.] Banks
would be expected to strike a middle ground between the possibility of loss and
the possibility of no loss.
To elaborate on the differences
between the two approaches, the incurred loss model only permits a bank to use
past events and current conditions to set its reserve. The expected loss model
is intended to be more forward-looking. That is, it would add forecasts of
credit conditions to past events and current conditions. Ultimately, losses
would be recognized earlier under the
That's the issue, in brief, but, as
usual, the devil is in the details. This article is based on an interview with Donna Fisher, senior vice-president of
tax, accounting, and financial management and Michael Gullette, vice-president, accounting and financial
management; an analysis of FASB's proposal and related documents; and an extensive Q&A that ABA published on the
FASB draft on Jan. 4.
Road to the current proposal
Genesis of the latest reserve
proposal was the belief that the current rules didn't leave the industry
prepared for the financial crisis.
"The impairment changes proposed in
this exposure draft are in response to the ‘too little, too late' criticisms
made during the financial crisis," says Fisher. "Some felt that banks were
inadequately reserved before the crisis, due to constraints of the current
incurred loss impairment model."
If adopted, "this will be a big
change for U.S. banks, and especially for community banks, even if you just
look at the kind of data they will have to keep in order to keep their loan
loss allowance model up to date," says Mike Gullette.
Elaborating, Gullette explains that
historically banks have worked from measures such as annualized chargeoff
rates. "But that won't be good enough anymore."
He explains that if a bank's
portfolio contractually would return 6%, but that sufficient nonperformance
would cut that to 4%, then the two-percentage-point difference would have to be
reflected in the allowance. "And that's whether you think there are problems
with any of those loans or not," says Gullette. This will apply for the life of
the loan, ABA says, though the term isn't explicitly used in the FASB exposure
On this point, the ABA Q&A
states in question 6:
"ABA believes most banks do not
currently have sufficient ‘life-of-loan' (LOL) loss data to support ALLL
estimates needed for the exposure draft. Bankers also realize the reliability
of their forecasts of the economy and credit performance diminish greatly past
one year--forecasting several years into the future can be a dream or a
nightmare, with neither providing good information to users of financial
statements. Therefore, ABA believes that for most banks, the type of
documentation that might be required for LOL loss allowances could start with,
on a practical basis, market data from Moody's or other rating agencies. Banks
will then have to make adjustments from this data to align with their specific
underwriting terms, geographic location, etc. Supporting the market data as
well as these adjustments will be very challenging, and changes to any assumed
loss rates, since they potentially apply to many years, could potentially add
significant volatility to the ALLL without improving the information.
"On the other hand, if the CECL emphasizes that a bank should just
estimate ‘what they can estimate' with reasonable confidence, without any
regard to whether a loss has been incurred, this may greatly reduce the changes
needed to the credit evaluation process." [Emphasis added.]
Fisher says ABA believes at this
time that allowances will likely rise when banks make the shift from the
current methodology to the expected loss approach. Institution by institution
this may vary, depending on whether a given bank has currently been releasing
reserves. Fisher adds that some bankers felt that they should have been
permitted to set higher reserves before and during the crisis. Even prior to
the crisis, reserves had been a matter of debate, with players such as the
Securities and Exchange Commission resisting reserve levels that it considered
part of a potential "earnings management" effort.
Multi-cultural debate goes on
Both FASB and its international
counterpart, the International Accounting Standards Board, favor a shift in
ALLL procedure, but do not currently agree on how to address it. The current
FASB proposal represents the organization's departure from a model that IASB
and FASB had been developing in cooperation. The split came in recognition of
differences in U.S. and international attitudes on reserves. The formerly joint
proposal was called the "three-bucket model." FASB stated in its recent In Focus newsletter that during outreach
to industry and users of financial statements it heard "significant concerns
that the three-bucket impairment model would not be understandable, operable, or
"The debate is over how to account
for your good loans, in setting the reserve," explains Fisher. "We all sort of
agree on bad loans. Some countries believe you should have no accruals for good loans, but in the U.S., we do. That's a big difference
and it's the dividing line philosophically between FASB and IASB." (Note that the proposal also addresses
reserving for other than temporary impairment for debt securities in banks'
portfolios. ABA opposes inclusion of debt securities in the FASB proposal.)
Fisher adds that a similar schism
has been seen, historically, on the Basel accounting committee, between U.S.
and other countries' regulators. She says she has heard that these regulators may
be coming closer together.
IASB is expected to publish its own
proposal in February. Here Fisher shares a bit of insight: "Many in the press
have indicated that FASB pulled away from the IASB and did their own thing.
Actually, the truth of the matter is that IASB refused to address the issues
that American banks needed to have addressed. And IASB refused to work with
FASB on those issues. So, FASB couldn't ignore its constituents [bankers,
regulators, and investors], who felt IASB's three=bucket model wouldn't work."
ABA has expressed to FASB the need
for both proposals to have the same comment period deadline in order to ensure
that both proposals can be fully explored and compared. The FASB's deadline is April 13, 2013,
and the IASB's is likely to be mid-June. Approval of a final rule may not occur
until the end of 2013 or possibly 2014, ABA believes, and implementation at
banks will not likely be required until 2015. Gullette says that early adoption
may be permitted, but it is hard to say at this time.
Outlook for change
Where the matter will go, and the
ultimate impact on banks, remains to be seen. There is a certain degree of
"creative tension," if you will, between the deliberations over reserves and
aspects of the original Basel III capital proposals.
In addition, ABA believes that some
of what regulators have been trying to accomplish over the last few years, by
requiring higher capital levels than would strictly be required under
risk-based capital standards, would be accomplished should the expected loss
proposal go through. Some pundits have talked about that with phrases like "10%
is the new 8%."
"Examiners have been saying,
‘You've met the minimum capital level, but because of risks in your portfolio
we're going to say you need 2% more'," says Gullette. "We think that should go
away" if the expected loss method is adopted as proposed.
"ABA has always believed that
estimating loan loss allowances is highly judgmental and bankers should be able
to reserve for amounts that are not necessarily supported closely by
quantitative models," the Q&A states in question 9. "ABA believes that past
efforts by the SEC to curb ‘earnings management' led bankers to minimize the
ALLL at times when it was needed the most. Therefore, ABA generally supports a
change from the strict incurred loss accounting standard for loans, though we
do not yet support a change for debt securities." ABA does have concerns about
the life-of-loan issue, as noted above and addressed in greater depth in its
One facet of the debate concerns
the users of financial statements, including bank analysts. In the course of
discussing analysts' needs, ABA notes in Question 9 that:
"Bank analysts tell ABA that they
generally believe banks should be reserving now for the ‘rainy day.' However,
that can be a very different concept than what is in a [life-of-loan] expected
loss model. While consideration of the economic cycle is a factor in the CECL
model, no ‘rainy day' fund exists. As a result, ABA expects all estimates to be
subject to rigorous support and documentation requirements that exclude
consideration of any ‘rainy day'."
And, speaking of rainy days, ABA
believes that banks will continue to need to account for troubled debt
restructurings under the proposed change.
"ABA has strongly encouraged both
the FASB and the banking agencies to eliminate TDRs," the association states in
question 12 of the Q&A, "because under an expected loss approach, the TDR
designation is unnecessary. Even though the banking agencies agree that TDR
accounting should be eliminated while improving disclosures about TDRs, the
FASB has chosen to retain TDR accounting."
Getting involved in ALLL debate
Many bankers will be concerned
about the FASB exposure draft. Member bankers who wish to be involved can join
ABA's working group. Contact
for more information.
Investors with an interest in this
issue can contact
[This article was posted on January 10, 2013, on the website of
ABA Banking Journal, www.ababj.com, and is copyright 2013 by the
American Bankers Association.]