A new accounting standard could accelerate the growth of nonbank financial companies, especially in the nonprime loans more common among borrowers with poor credit scores.
The current expected credit loss accounting standard, or CECL, will change how U.S. financial companies provision for loan losses and becomes effective for much of the industry on Jan. 1, 2020. Bankers have said they expect the standard will increase loan loss reserves by 20% to 50%, incrementally affecting the capital levels that often govern a bank's ability to extend credit.
Nonbanks include companies like Quicken Loans Inc. or PayPal Holdings Inc., which offer financial services but do not have a banking charter. While nonbanks also have to comply with CECL, the capital impact will not be as severe, said Henry Coffey Jr., an analyst who covers specialty finance companies for Wedbush Securities. Banks have strict capital ratios they have to meet or risk regulatory sanction. In contrast, nonbanks' capital needs are governed by rating agency evaluations since credit ratings essentially determine the companies' funding costs, Coffey said.
"For now, the rating agencies are treating it as balance sheet geography," Coffey said in an interview. "The rating agencies are talking about it as part of their primary capital. The banks don't have that freedom, so that, to us, is the [differentiating factor,] and that will change behavior and restrict credit."
In recent years, nonbanks have increased their market share in certain product types, especially mortgages. The companies face lighter regulation than banks and tend to cater to borrowers with lower credit scores than a typical bank client. Financial regulators expressed concern in a Dec. 4 financial stability report because nonbanks tend to be less stable, which could leave borrowers unable to access credit in a downturn. U.S. Treasury Secretary Steven Mnuchin also highlighted the risks posed by nonbanks in Dec. 5 congressional testimony.
Most banks have said CECL will increase reserves, and several have gone a step further, projecting that the new accounting standard will trigger a reconsideration of lending practices.
At a recent investor conference, a JPMorgan Chase & Co. executive said the accounting standard could complicate the bank's capital ratios, especially in an annual stress testing exercise.
"To the extent that those levels of requirements become the binding constraint, then you would see that, over time, translating into risk appetite and into credit availability or pricing," said Sarah Youngwood, CFO of the bank's consumer and community banking division.
In the third quarter, Associated Banc-Corp management said the bank sold $240 million of mortgages to prepare for CECL and to manage interest rate risk. Mortgages are particularly affected by the accounting standard because of their lengthy maturity, which accentuates the lifetime loss consideration required by CECL.
At the same conference, Citizens Financial Group Inc. CFO John Woods said CECL could change credit decisions in mortgage and student loans due to the long maturity for these product types. He said the bank would not reduce its overall exposure to these kinds of loans but that CECL could change what types of mortgages and student loans it originates.
"We wouldn't want to reduce our overall capital that we're allocating to students, but we'll optimize within categories with the new signals from CECL," he said.
Effects on low-income borrowers
The new accounting standard will have the most significant impact on nonprime loans since they require larger reserve increases, translating to larger capital hits, said Joe Stieven, founder of Stieven Capital Advisors, an investment firm focused on banks.
"When you think about what's most affected, think about who has the highest charge-off rates and the highest loss rates," Stieven said in an interview. "It's that simple."
Nonprime defines any type of loan that fails to meet the strict underwriting criteria for prime loans. Wealthy borrowers might need nonprime loans if they have poor credit scores or have difficulty proving a regular source of income. But academic research shows either a strong or moderate correlation between income and credit scores, meaning low-income borrowers are more likely to have poor credit scores that require access to nonprime credit.
Banks will need to continue lending to low-income borrowers to comply with the Community Reinvestment Act and avoid scrutiny from the Democrat-led House Financial Services Committee, said Mayra Rodriguez Valladares, managing principal of banking consultancy MRV Associates. Still, she said it is likely CECL will force banks to increase their pricing on loans.
"It will cause banks to charge more," she said in an interview. "Anytime you have to account for the riskiness of the loan upfront, it will lead to charging more."
A price increase could further drive borrowers toward nonbanks over banks. Nonbanks already have most of the overall mortgage market and a dominant share in nonprime mortgages. Across all mortgages, nonbanks accounted for 71% of origination volume in November, according to a report by the Urban Institute Housing Finance Policy Center. For mortgages sold to Ginnie Mae, which have a significantly lower median credit score than loans sold to Fannie Mae or Freddie Mac, the nonbank market share was 85%.
During earnings calls, bankers have repeatedly said nonbanks are winning market share with more competitive pricing or more aggressive loan structures. With CECL hitting banks' capital ratios, nonbanks might find opportunity to take even more share.
"The nonbanks have a competitive advantage because of CECL. The question is going to be: How big is that advantage and how does it shift behavior?" said Coffey. "We obviously don't know precisely, but it seems clear the banks are looking at their capital ratios and saying, 'This is going to make us less experimental, make us less likely to go down FICO.'"