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CECL delay's effect on balance sheets would split public US banks into 2 groups

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CECL delay's effect on balance sheets would split public US banks into 2 groups

The Financial Accounting Standards Board's plans to delay implementation of a new reserve methodology will create two separate operating environments for publicly traded banks, and that could create some confusion for investors evaluating bank balance sheets.

While the majority of publicly traded banks will still comply with the new reserve methodology, dubbed the current expected credit loss model, or CECL, in 2020, many banks with a significant investor following might not have to adopt the provision until 2023. That would leave investors with two sets of banks operating side-by-side with different models for several years and could create less transparency around bank balance sheets, a stated goal of the new provision.

CECL aims to speed up the recognition of credit problems by requiring institutions to reserve for estimated losses at origination as opposed to building allowances when a loss is probable. That likely will cause reserves to increase at adoption for most institutions, but FASB recently proposed delaying implementation for most banks until 2023.

If finalized, smaller reporting companies, or SRCs, and private companies would have until January 2023 to implement CECL. The SEC defines an SRC as a company having a public float of less than $250 million, or one that has annual revenue less than $100 million with either no public float or a public float of less than $700 million. An entity's status as an SRC is determined annually based on the last business day of the company's most recent second quarter and its annual revenue in the most recent fiscal year completed before the last business day of the second fiscal quarter.

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More than 92% of institutions in the U.S. banking industry will have to comply with the new reserve methodology in 2023 if the delay is passed, three years after their generally larger peers, S&P Global Market Intelligence found. The analysis included currently operating banks and thrifts and SRC-qualifying criteria based on the June 30 public float of an institution and the revenue for the full year 2018 for most companies.

The institutions are largely small, holding just 7.5% of the industry's assets and 15.2% of the industry's loans. But 179 trade on a major exchange, representing close to 44% of banks trading on a major exchange. The banks qualifying for the delay have a fairly healthy following from institutional investors, reporting a median institutional ownership of 26.5%.

Still, the banks with the largest institutional following will have to comply with CECL in 2020. The median institutional ownership at those institutions is over 70%.

Like many community banks, institutions qualifying for a delay tend to carry more capital and hold higher reserve balances than their larger counterparts. The median tangible equity-to-tangible assets ratio among banks qualifying for CECL implementation in 2023 was 10.81% at the end of the first quarter, compared to 9.67% at institutions adopting the provision in 2020. The so-called 2023 group's reserves equated to 1.20% of loans at the end of the first quarter, compared to 0.94% among the 2020 group.

The loan portfolios at the institutions receiving a potential CECL delay are notably different than their larger counterparts, too. The former hold lower concentrations of commercial real estate loans and also make far fewer commercial and industrial loans. That distinction is important since, in theory, banks with higher concentrations of longer-dated assets will require larger reserve builds when adopting CECL since banks will have to reserve for lifetime expected losses. The more time that passes, the greater potential for losses, and CRE loans have an average life that is several years longer than C&I credits on average.

Smaller institutions, which make up the bulk of banks qualifying for the delay, also do not have the same resources as larger banks. Most large institutions have teams dedicated to stress testing that could help develop a forecast required at CECL adoption. Smaller banks, meanwhile, have long argued that complying with CECL will prove too difficult for them given the complexity associated with the provision. The proposed delay was welcomed by the Independent Community Bankers of America, but some community banks still argue it would not be not enough.

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While small banks already have differences with their larger counterparts, the reprieve would create an even greater divide since reserves at the two groups of banks will diverge after 2020. Reserves could swing notably during an economic downturn, and many economists expect one to occur in the next few years.

The Wall Street Journal's monthly survey of more than 60 economists showed in June that 49% of respondents expect the next recession to occur in 2020, followed by 36.6% expecting it in 2021. Just 2.4% of economists predict that a recession could occur in 2023, the new CECL implementation time frame for most banks.

If the delay is passed, CECL likely will require considerable reserve increases over the next few years, while banks qualifying for the delay may not build their reserves until losses begin to materialize and the economic cycle turns. That dynamic could prevent CECL from being counter-cyclical as intended for the vast majority of institutions, while also making it harder for investors to compare many publicly traded banks against one another.