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In loan loss accounting, regulators do not make one size fit all

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In loan loss accounting, regulators do not make one size fit all

If current practice is any judge, regulators could make good on their word to allow community banks flexibility and discretion in their allowance for loan and lease losses under the new accounting standard, according to a paper presented at the 2017 Community Banking in the 21st Century research conference Oct. 4.

Michelle Neely, an economist at the Federal Reserve Bank of St. Louis, wanted to assess the effect of the new credit loss standard, which becomes effective for some banks in 2020. She looked at current accounting precepts and found that bank examiners currently do not constrain community banks into a "one-size-fits-all" approach when it comes to the relationship of loan loss provisioning to charge-offs quarter over quarter. Her analysis found that "bank supervisors have long been able to reconcile rules and principles, implicitly if not explicitly" and that "they have … been able to create 'oxygen' for themselves in which to exercise judgment," according to the paper.

That could bode well for community banks once the new credit loss standard, called the current expected credit loss model, or CECL, takes effect. Neely pointed out that CECL, an arguably more complex accounting standard that requires banks to set aside lifetime loan losses at origination, comes at a time when there is increased interest in regulatory reduction.

"Regulators for their part have been trying to assure community bankers that this new accounting rule will be scalable or tailored and they can use discretion and judgement … that there's no reason to be so fearful of CECL," she said. "So we thought it was reasonable to ask if community banks can feel confident that this tailoring will take place. One way to perhaps answer that question is to look at how current accounting rules are applied."

Her research specifically examined how regulators treat reserving at banks with less than $10 billion in assets, dividing banks into several asset sizes and looking at institutions that had external auditors as well as some without. Under current accounting rules and guidance, there should be a strong correlation between loan loss provisioning and subsequent charge-offs. While she did see that relationship, the data from smaller banks showed a less-closely correlated association.

She said this is evidence that there is "tailoring" and the "use of discretion" for smaller banks, with deviations from the strict conformance of the rules. She saw this in all subsets of her analysis, including whether the bank had an external auditor and across management scores from regulators. The tolerance for deviation was sustained over a long period of time, and was not a short-term act of forbearance in regulating.

"It seems to indicate there's a greater tolerance of regulators for a wide-range of outcomes among smaller banks — one size doesn't fit all," she said.