The coronavirus pandemic is adding complications to banks' plans to implement a major accounting change and will likely ding their earnings in the first quarter, analysts say.
Banks were already working to figure out how this year's switch to the new current expected credit loss accounting standard, or CECL, will impact the reserves they are required to set aside to guard against the probability of a loan going sour.
Now, the coronavirus and growing fears about a global recession have thrown a wrench into that planning. CECL requires banks to set aside reserves for the lifetime expected losses on loans as soon as they originate them, a method that is sure to lead to a substantial increase in banks' provisioning this quarter given the expected weakening of economic growth. Banks have historically set aside those reserves as soon as losses on loans become probable, rather than CECL's requirement for up-front provisioning.
Banks had already planned to set aside a large chunk of reserves on Jan. 1, when the new CECL standard went into effect for many larger institutions. But global growth expectations looked far sunnier at the start of the year, when a manufacturing slowdown seemed to have reached a bottom and the U.S. and China were on their way to reaching a major phase one trade deal.
The coronavirus has heightened the risk of a recession, though the situation remains uncertain and many banks are planning for a range of possible outcomes, said Joseph Breeden, CEO of the consulting firm Prescient Models.
"You definitely have to read the fine print on these things," Breeden said of banks' upcoming estimates of the coronavirus' effect on their CECL provisioning. "When times are good, everybody's scenarios look more or less the same. When times are bad, the scenarios probably look really similar. But the transitions are really hard."
It remains unclear whether the U.S. economy will tip into a recession, but several economists say it is growing increasingly difficult to avoid.
"A recession looks inevitable; the focus now is how deep and how long?" TD Securities' Jim O'Sullivan and Priya Misra wrote in a note to clients.
The Federal Reserve slashed its benchmark interest rate on March 15 to near-zero levels for the first time since the financial crisis, with Fed Chairman Jerome Powell telling reporters he expects second-quarter growth to be "weak" but that it is "very hard to say" how much the coronavirus will affect growth beyond that.
Another development that is sure to weigh on the outlook is the oil price war between Saudi Arabia and Russia, which is already rattling the U.S. energy sector and raising default risks for companies in that space. In one sign of pain for banks, several with large energy exposures saw their shares tumble more than 20% during the widespread sell-off on March 9.
Banks have already put out their estimates for the Day 1 effects of CECL — that is, how much they would have to increase their provisions when CECL took effect on Jan. 1. Although they may have a bit of wiggle room to tinker with those estimates, particularly if they had offered a range of outcomes, analysts say those Day 1 figures are largely set in stone and that banks cannot retroactively add the coronavirus-induced uncertainty to Day 1 figures. Doing so would be "very difficult" to pass by auditors, according to Maria Mazilu, vice president at Moody's Investors Service.
"I don't really expect to see any of this in Day 1," Mazilu said.
Instead, the coronavirus effects will be reflected in the so-called Day 2 effects of CECL, a quarterly process that banks will undergo to decide their provisioning each quarter going forward. Although a few banks have put out guidance on the Day 2 effects of CECL, the new economic environment will likely prompt them to judge that their estimates were not high enough, said Brian Klock, an analyst at Keefe Bruyette & Woods.
Banks are beginning to caution to investors that the coronavirus uncertainty will cause increases in provisioning this quarter. Unlike the Day 1 hit from CECL, which comes from banks' existing capital levels and which regulators have phased in, the ongoing provisions flow through banks' income statements. That will come at a time when bank income is already coming under pressure from the Fed's rate cuts starting in 2019, actions that will continue to squeeze how much banks can earn from the loans they make.
Peter Guilfoile, chief credit officer at Comerica Inc., said during a March 10 investor presentation that while the Dallas-based bank expects no major changes to its credit quality this quarter, the economic scenario that will guide their CECL provisioning will not be "as attractive" as it was at the start of the year.
American Express Co. CFO Jeffrey Campbell expressed a similar sentiment at a March 4 event, saying he sees "nothing but continued strength in our credit performance across the globe" but encouraging investors to take an "annual view" of the industry's CECL provisioning given the expected volatility this quarter.
"It's going to be very interesting to see what judgments we're all going to have to make about what economic forecasts look like at March 31," Campbell said, according to a transcript.
The Financial Accounting Standards Board, which developed the CECL standard partly due to the strains banks saw during the 2008 financial crisis, said in a March 10 statement that CECL gives companies the flexibility to estimate their expected credit losses based on their historical experiences and "reasonable and supportable forecasts" about the credit cycle.
"As conditions change, the standard requires a company to consider what, if any, changes to make to its estimate of expected credit losses," FASB member Hal Schroeder said in a statement.
Each bank's flexibility in deciding how to implement CECL will make it tougher for bank analysts and investors to compare quarterly earning results, Moody's Mazilu said.
The possibility of a recession will also test a hypothesis that CECL critics, including those on Capitol Hill, have raised: will the accounting change make banks more likely to pull back on consumer lending right as the economy needs credit to keep flowing?
Powell and other top regulators have said they do not expect that to happen but would closely monitor CECL's effects, and Congress has tasked the Treasury Department with conducting a quantitative study on the issue. The Wall Street Journal also reported on March 15 that regulators are weighing whether to give banks additional flexibility by delaying the capital hit from CECL for one year.
It is too early to say how banks' lending patterns will change under CECL, Mazilu said. But even if they tighten their credit standards, it will be hard to determine whether that is because of CECL or due to their historical tendency to do so when the economic outlook deteriorates, she added.
"Could they pull back from lending at some point if things get really bad? I think it's hard to say that it's not a possibility," she said. "But I've always wondered: Wouldn't they have done it anyway?"