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Banking & Financial Services

CECL Could Create Large Capital Shortfall For Community Banks

C&I Loan Growth Pops In Q2, But Tax Reform’s Role Remains Unclear

Banking

StreetTalk Episode 27: Looking For The Cream Of The Crop In Bank Stocks

Loans And Deposits Continue Uphill Climb At US Banks In June

Peeking Into The Future Without Staring At A Crystal Ball: Brexit Scenarios And Their Impact On Energy Firms’ Credit Risk


CECL Could Create Large Capital Shortfall For Community Banks

Feb. 02 2018 — The implementation of a new accounting standard that changes the way banks reserve for loan losses could have a far more punitive impact on community banks than their larger counterparts.

The accounting standard, known as the current expected credit loss model, or CECL, becomes effective for many institutions in 2020 and will require banks to set aside reserves for lifetime expected losses on the day of origination.

The new standard will mark a considerable shift in how banks currently reserve for losses. Today, banks record losses when it becomes probable that a loan will be impaired. That means reserves are dispersed over time, but CECL will cause banks to significantly build their allowance for loan losses on the date of adoption, according to Josh Siegel and Ethan Heisler.

The two bank observers said in the latest Street Talk podcast that the increase will be even larger for institutions with higher concentrations of longer-term loans since reserves for those credits are currently spread out over longer periods.

"The same credit, the same view, the same company, if you have a two-year loan or a 20-year loan, the reserve you're going to have to put it against it is dramatically different," Siegel, managing partner and CEO of StoneCastle Partners LLC, an investor and adviser to community banks, said in the episode.

He said a reserve for a loan with a two-year term under CECL might not be dramatically different than the current methodology since it requires banks to look ahead 12 to 18 months for losses. Loans with far longer terms such as real estate credits, however, could require multiples of currently required reserves. The burden of the new accounting standard could prove far greater for community banks since those institutions are much more heavily concentrated in real estate.

Siegel and Heisler — president of the Bank Treasury Newsletter, which highlights industry trends impacting bank treasurers — co-authored a white paper analyzing CECL's impact on banks with less than $50 billion in assets. The analysis found that hundreds of banks could be at risk of falling below well-capitalized status after adopting CECL, at least when it comes to meeting total risk-based capital requirements. Any reserve build required through CECL will be deducted from capital and could have the greatest impact on total risk-based capital ratios because the Basel III rules cap the inclusion of reserves at 1.25% of risk-weighted assets.

The required build under CECL could push reserves well above that level, according to Siegel and Heisler's analysis. They examined the banking industry's results since 2004 and assumed institutions adopted CECL beginning in 2005. The analysis further assumed that all loan portfolios had five-year terms, loans were originated at year-end and bankers were fully aware of the losses that would come between 2005 and 2016. The analysis assumed provisions equaled cumulative net charge-offs in the five years after adoption and considered a number of scenarios, with CECL implementation beginning in different years.

In the most severe scenario, where banks would have adopted CECL beginning in 2007, the analysis found that banks in aggregate would need as much as $70 billion to repair the capital shortfall. In the least severe scenario, with CECL adoption beginning in 2011, banks would need to raise close to $10 billion.

"It's not just a small change. You could today be very well-capitalized and wake up and not even be adequately capitalized," Siegel said. "You could be deemed undercapitalized and immediately be put under a cease and desist order."

Siegel said banks should begin calculating CECL's impact, even in a rough approximation, to see if they have a capital shortfall. For an institution falling short, they recommended that banks should consider issuing subordinated debt to bolster their balance sheets.

Siegel has encouraged community banks to utilize sub debt in the past, given that it allows banks with holding companies to raise funds, downstream them to their banking subsidiaries and count them as equity capital in far more cost-effective manner. He and Heisler noted that issuing sub debt today remains relatively cheap while interest rates continue to be low.

"Sub debt is a natural offset, a way to prepare for CECL," Heisler said in the episode. "Think of Tier 2 sub debt almost as a CECL buffer."

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Banking & Financial Services
C&I Loan Growth Pops In Q2, But Tax Reform’s Role Remains Unclear

Jul. 31 2018 — Business loan growth popped in the second quarter, but bankers are hesitant to attribute the jump to tax reform or a broader turnaround in business spending.

The year-over-year increase in commercial-and-industrial loans increased to more than 5% for all banks in June, the highest figure in more than a year, according to Federal Reserve data. Smaller U.S. banks — defined by the Fed as those outside the 25 largest banks — posted double-digit growth for all three months of the second quarter.

Those numbers were artificially inflated by banks' acquisition of $24.9 billion of C&I loans from nonbanks. Accounting for those one-time acquisitions, organic C&I loan growth for smaller banks was still robust at 7% in June.

Ever since Republicans passed tax reform at the end of 2017, business optimism has been high and bankers have been hopeful the sentiment will trigger a rebound in business loan growth. C&I loan growth was less than 1% when tax reform passed.

Though C&I loan growth enjoyed a significant bounce in the second quarter, several bankers were not declaring victory. Numerous bank executives attributed the jump to an increase in merger-and-acquisition activity, not increased business spending.

M&T Bank Corp. said M&A activity was hurting its average loan growth, which declined by less than 1% on a quarter-over-quarter basis. The bank's CFO said businesses are selling significant assets and using the proceeds to pay down their loans.

One bank did say tax reform was boosting loan growth. SunTrust Banks Inc. reported an increase in the second quarter for its average performing loans figure, a turnaround from the first quarter when the figure declined on a linked-quarter basis.

"I think we are starting to see some of that [benefit from tax stimulus]," said Chairman and CEO William Rogers Jr. in the bank's earnings call.

But Rogers appeared to be in the minority. Several bankers said it was too early to tell whether tax reform was playing much of a role in the C&I loan growth. JPMorgan Chase & Co. reported a 3% quarter-over-quarter increase in its C&I loans in the second quarter and attributed the gain to M&A financing, not tax reform.

"We've yet to see the full effect of tax reform flow through into profitability and free cash flow," Lake said during the bank's earnings call.

Some bankers, including JPMorgan CEO Jamie Dimon, pointed to brewing trade wars as potential headwinds to loan growth.

Tariffs and trade-related issues are "probably the primary concern that we're hearing from customers right now," said Comerica Inc. President Curt Farmer.

Jeff Rulis, an analyst with D.A. Davidson, said he was not even sure the second-quarter C&I loan growth figures represented a notable change.

"I'm not convinced we're seeing a turnaround or significant pick-up. You have to take into account seasonal pick-up, and the first calendar quarter is generally slow," he said.

There is an argument that tax reform might actually be dampening loan growth. Rulis attributed high payoffs to the mixed results across the sector with some banks reporting robust loan growth by taking market share, contributing to others' more marginal results. Businesses are having an easier time making those payoffs thanks to tax reform, which freed up capital to pay down debt.

"One of the disadvantages of tax reform is you've both lowered the corporate tax rate and repatriated assets to the U.S. That's given more liquidity to the borrowers," said Peter Winter, an analyst with Wedbush Securities.

Year-over-year increases for total loans were up modestly, as weak commercial real estate loan growth moderated the gains from C&I. The 25 largest banks, in particular, reported soft commercial real estate loan growth with year-over-year declines in March, April and May — the first such drops since 2013. Several banks reported an intentional pullback from the sector due to credit quality concerns. Some pointed to nonbank competition as being particularly aggressive on both pricing and deal structure.

"I think banks, for the most part, are showing more credit discipline coming out of the financial crisis," Winter said. "Quite honestly, we're nine years into this recovery, so I think that's a prudent thing to do."

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Listen: StreetTalk Episode 27: Looking For The Cream Of The Crop In Bank Stocks

Jul. 30 2018 — Joe Fenech, head of equity research at Hovde Group, discussed current bank stock valuations, the growing importance of deposits in valuing franchises and the market's increased skepticism toward M&A, including transactions that appear favorable for the buyer.

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Banking & Financial Services
Loans And Deposits Continue Uphill Climb At US Banks In June

Jul. 26 2018 — Average total loans and leases at U.S. commercial banks increased by $44.10 billion to $9.347 trillion in June, according to the Federal Reserve's July 13 H.8 report.

Loan growth was driven primarily by a $19.8 billion increase in commercial and industrial, a $9.4 billion jump in real estate and an $8.3 billion increase in commercial real estate.

Average loans and leases at large commercial banks increased $18.7 billion month over month, while average loans and leases at small commercial banks were up $21.7 billion. Loans and leases at foreign-related institutions increased by $3.4 billion.

Meanwhile, average total deposits at U.S. commercial banks increased by $56.4 billion in June, compared to a $35.4 billion increase in May. Total deposits were up $448.4 billion from June 2017.

CECL Could Create Large Capital Shortfall For Community Banks

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Credit Analysis
Peeking Into The Future Without Staring At A Crystal Ball: Brexit Scenarios And Their Impact On Energy Firms’ Credit Risk

Jul. 24 2018 — After so many years of living and working in London, two years ago I applied for, and was finally granted, British citizenship. Imagine my surprise when, a few weeks later, the UK European Union referendum took place and the majority of voters opted for Brexit!

As a dual national, both European and British, I feel twice the pain of an uncertain future and sometimes I wish I had a crystal ball.

While it is hard to predict how the whole separation process will pan out, S&P Global Market Intelligence offers a new statistical model that allows users to understand how firms’ credit risk on either side of the ocean may change under multiple exit scenarios. The Credit Analytics Macro-scenario model covers the United States, Canada and European Union countries plus the United Kingdom (EU27+1). In addition, the model can be run via the S&P Global Ratings’ Economists macro-economic multi-year forecasts, tailored for this specific model and updated on a quarterly basis.1

Figure 1 shows the Economists’ forecasts of the inputs used in our statistical model for EU27+1, for year-end 2018, 2019 and 2020.

Source: S&P Global Market Intelligence (as of June 2018). For illustrative purposes only. L/S ECB Interest rate spread is the spread between long-term and short-term ECB interest rates. Y-Axis is % of; GDP Growth, Stoxx50 Growth, Interest Rate Spread or FTSE100 Growth, depending on the correlating symbol as described in the key.

The expectation is for economic growth to slow-down in the EU27+1. This will be accompanied by progressive monetary policy tightening and a volatile performance of the stock market index growth. This view is aligned with the baseline scenario included in the European Banking Authority (EBA) and the Bank of England (BoE) 2018 stress testing exercise that “[…] reflects the average of a range of possible outcomes from the UK’s trading relationship with the EU”.2

Figure 2 shows the evolution of the median credit score of Energy sector (left panel) and Utility sector (right panel) large-revenue companies in EU27+1, obtained by running the economists’ forecasts via the Macro-scenario model.3 The median score for 2017 is generated via S&P Global Market Intelligence’s CreditModelTM 2.6 Corporates, a statistical model that uses company financials and is trained on credit ratings from S&P Global Ratings.4 The model offers an automated solution to assess the credit risk of numerous counterparties, globally. The scores are mapped to a numerical scale where, for instance, bb- (left panel, left scale) is mapped to 13.0; a deterioration by 1 notch corresponds to an increase of one integer on the numerical scales.

Figure 2: Evolution of the median credit score of Energy and Utility sector companies in EU27+1, based on S&P Global Economists’ macro-economic forecasts run via the Macro-scenario model.

Source: S&P Global Market Intelligence (as of June 2018). For illustrative purposes only.

Starting from 2017, we see a higher level of credit risk in the UK (red line) than in EU27 (blue line); in subsequent years, the median credit risk increases on both sides of the Channel but the “risk fork” between the UK and EU27 tends to widen up at the expenses of the UK, for both sectors.5

Despite the fact that the median credit score may not change sizably between 2017 and 2020, remaining below half a notch overall in all cases, it is worth keeping in mind that the probability of default (PD) associated with a credit score changes in line with the economic cycle, and thus increases (decreases) during periods of contraction (expansion).

In our model, we account for this effect by first mapping the credit score output to a long-run average PD; next we scale it via a “Credit Cycle Adjustment” (CCA) that looks at the ratio between the previous year and the long-run average default rate historically experienced in S&P Global Ratings’ rated universe.6 If we adjust the long-run average PD via the CCA, we can easily identify potential build-up of default risk pockets in different countries within the EU27+1 as time evolves, as shown in the animations within Figure 3. Green refers to a lower PD than 2017, orange refers to a higher PD than 2017, and red refers to a PD breaching a pre-defined threshold (4.5% for Energy Sector and 0.3% for Utilities sector).7

Figure 3: Potential pockets of default risk in Energy and Utility sector companies in EU27+1, based on S&P Global Economists’ forecast.

Energy Sector Utility Sector
Default Risk in Energy map Default Risk in Utilities map

Source: S&P Global Market Intelligence (as of June 2018). For illustrative purposes only. Green refers to a lower PD than 2017, orange refers to a higher PD than 2017, and red refers to a PD breaching a pre-defined threshold (4.5% for Energy Sector and 0.3% for Utilities sector).

With the Macro-scenario model, we aimed for a user friendly model, and took into account the strong economic ties within EU27+1, the existence of a common market and the circulation of a shared currency in the majority of the EU countries, in order to select a parsimonious yet statistically significant set of inputs (just imagine otherwise forecasting multiple macro-economic scenarios for 28 individual countries, over multiple years).8

Readers may wonder how the model differentiates the evolution of credit risk by country if it uses a limited set of aggregate macro-economic factors (e.g. EU28 GDP growth, etc.) across EU27+1. Nine separate sub-models were actually optimized, based on economic commonalities and historical evolution of the S&P Global Ratings transitions in those countries, to account for the existence of different EU “sub-regional” economies (for instance Nordic countries as opposed to Eastern European countries). For the UK, we went one step further, by explicitly including a market indicator, the FTSE100, as a precautionary measure given a potential “full decoupling” of EU27 and UK economies in the near future.

Well, so far so good, at least in the case of a “soft” Brexit! But what if we end up with a “hard” Brexit?

The EBA and the BoE 2018 stress testing exercise include a stressed scenario that “[…] encompasses a wide range of economic risks that could be associated with {hard} Brexit”.9 The scenario corresponds to a prolonged recessionary period, with negative GDP growth for several years and a generalized collapse of the stock markets, similar to what happened during the 2008 global recession. Unsurprisingly, the median credit score output by our macro-scenario model companies significantly deteriorates for both Energy and Utility sector. Figure 4 shows the build-up of potential default risk pockets and their evolution over time, under stressed economic conditions, depicting a bleak view over the length of time needed for a recovery of these sectors.10

Figure 4: Potential pockets of default risk in Energy and Utility sector companies in EU27+1, based on EBA’s and BoE’s 2018 stressed scenario.

Energy Sector Utility Sector
Default Risk in Energy map Default Risk in Utilities map

Source: S&P Global Market Intelligence (as of June 2018). For illustrative purposes only. Green refers to a lower PD than 2017, orange refers to a higher PD than 2017, and red refers to a PD breaching a pre-defined threshold (4.5% for Energy Sector and 0.3% for Utilities sector).

I do not have yet a crystal ball to predict the future, e.g. whether petrol will cost more or less, or whether I will be paying higher utility bills in the UK as opposed to (the rest of) the European Union, but S&P Global Market Intelligence’s Macro-Scenario allows gauging potential credit risk changes in individual countries, under a soft or a hard Brexit scenario. More in general, the Macro-Scenario model offers a quick, scalable and automated way to assess credit risk transitions under multiple scenarios, thus equipping risk managers at financial and non-financial corporations with a tool that enables them to make decisions with conviction.

Notes

1 The macro-economic forecasts will become available on the S&P Capital IQ platform from 2018Q4. S&P Global Ratings does not contribute to or participate in the creation of credit scores generated by S&P Global Market Intelligence.

2 Source: “Stress Testing Exercise 2018” available at http://www.eba.europa.eu/risk-analysis-and-data/eu-wide-stress-testing/2018. The baseline scenario is the consensus estimate among EU27+1 Central Banks.

3 The results of this analysis depend on the portfolio composition. In addition, other industry sectors may react differently from the Energy and Utility sectors.

4 S&P Global Ratings does not contribute to or participate in the creation of credit scores generated by S&P Global Market Intelligence. Lowercase nomenclature is used to differentiate S&P Global Market Intelligence credit scores from the credit ratings issued by S&P Global Ratings.

5 The 2017 median score for the Utility sector is better than the score for the Energy sector, due to the inherently higher risk of companies in the latter.

6 An optional market-view adjustment is available within the macro-scenario model. In our analysis, we did not include this adjustment, for the sake of simplicity.

7 4.5% (0.3%) is close to the historical long-run average default rate of companies rated B- (BBB-) by S&P Global Ratings.

8 This is also one of the reasons we found it unnecessary to include oil price for the modelling of credit risk of the energy sector in EU27+1, as we found the stock market growth was sufficient.

9 Source: “Stress Testing Exercise 2018” available at http://www.eba.europa.eu/risk-analysis-and-data/eu-wide-stress-testing/2018. The baseline scenario is the consensus estimate among EU27+1 Central Banks. Curly brackets refer to the author’s addition.

10 We adopt the same colour conventions as in Figure 3.

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