Could CECL have made the Great Recession not so great?
The Current Expected Credit Loss model, or CECL, was created in the ashes of the credit crisis to change the way banks reserve and to speed up the recognition of loan losses. An S&P Global Market Intelligence analysis finds that if the industry had adopted CECL before the depths of the Great Recession, banks would have fared better, even if they failed to foresee the severity of their ultimate losses. But some institutions might have been forced to raise capital when bank stocks were falling out of favor, underscoring the importance of capital planning ahead of compliance with the provision.
Most banks will adopt CECL in 2020. It will require them to set aside reserves for lifetime expected losses on the day of loan origination, as opposed to setting aside reserves over time. S&P Global Market Intelligence recently projected that reserves would peak at 3.86% of loans in 2021, a year after banks will have implemented CECL, based on our expectation for future credit losses. Given the magnitude of the expected reserve increase, we wondered how large the reserve build would have been if banks had adopted the provision before the last major financial meltdown.
We estimated how CECL would have changed the industry if banks had adopted the provision Jan. 1, 2008, to see if the new reserve methodology would have better prepared banks for the credit crisis. We created two scenarios — a "crystal ball" scenario that assumes banks had perfect foresight of the losses that occurred through the downturn and a "plausible" scenario that aims to replicate how banks would have reserved for future losses based on information available at that time.
Major 2008 CECL scenario assumptions: Banks would base their short-term macroeconomic outlook for GDP, unemployment and interest rates on consensus estimates in the summer and fall of 2007, according to The Wall Street Journal's survey of more than 60 economists at the time. Longer term, banks would look at historical experience, including the brief recession in 2001, as a basis for their outlook to determine the required level of reserves. Loan portfolios had a weighted average life of 3.5 years, based on the loan composition of the industry. Reserves would equal cumulative net charge-offs in the 3.5 years after CECL adoption. Average life of loans: mortgages - seven years; multifamily loans - six years; commercial and industrial loans - 1.6 years; commercial real estate credits - 3.8 years; and consumer loans - two years. All other metrics in our banking industry projections model remained the same for 2008-2012, other than reserves and the loan loss provision. |
Running CECL through the Great Recession
CECL will allow banks to use various methods to estimate future losses, and banks will not be required to forecast beyond a reasonable and supportable period, which many institutions peg at 12 to 18 months. After that point, banks will rely on historical experience.
In our plausible scenario, we assumed banks would begin preparing for CECL implementation in the summer of 2007 and base their macroeconomic outlook on the consensus among economists. At that point, economists still expected healthy GDP growth and low unemployment through the remainder of 2007, and nearly 3% GDP growth and little change in unemployment in 2008, according to The Wall Street Journal's survey of more than 60 economists in June 2007.
Economists did not appreciate how severe the housing crisis would be, with 74% of those polled by the Journal believing that the worst of the housing bust had already occurred. Meanwhile, nearly two-thirds of economists said they had not lowered their economic forecasts due to problems in the subprime mortgage market.
Those troubles were quite visible to banks in the summer of 2007 and had resulted in significant stress in the markets, including the bankruptcy of subprime mortgage lender New Century Financial in April 2007, the failure of two Bear Stearns hedge funds focused on mortgage-backed securities in July 2007 and bankruptcy fears at mortgage behemoth Countrywide Financial in August of that year. Our analysis assumes that banks would continue to monitor credit performance through the 2007 third quarter as well as updates to the economic outlook through the fall of 2007.

Given the level of stress that had occurred by that point, it is reasonable to assume that the industry would expect credit to sour but would have failed to project the ultimate severity of losses. Our analysis assumes that institutions would have based their outlook on a much milder downturn akin to the brief recession that occurred in 2001.
Using that credit experience as a guide, our plausible scenario estimated that banks would reserve for aggregate net charge-offs of $269.3 billion between 2008 and 2012, or roughly 41% of the actual levels reported by banks during the same period.
If the industry had implemented CECL under our plausible scenario, reserves would have risen to 2.60% in 2008 before peaking at 2.83% in 2009. The industry's tangible equity-to-tangible assets ratio would have fallen to 6.57% at implementation in 2008.
During the credit crisis, the industry's reserve ratio reached an actual high point of 3.15% in 2010, and the tangible equity ratio bottomed at 6.82% in 2008.
Meanwhile, if banks had a crystal ball and reserved for the actual amount of net charge-offs that would occur in the 3.5 years beginning in 2008, reserves would have risen to 6.68% of loans in 2008 and peaked at 7.21% of loans in 2009. In that crystal ball scenario, the industry's tangible equity levels would have plummeted to 3.77% in 2008.
Capital planning through CECL's looking glass
Banks almost certainly would not have adopted such a severe outlook even if they had predicted the depths of the Great Recession. But if they had adopted the loss estimates in our plausible scenario, the industry would have been better prepared for the credit crisis since reserve builds would have been smaller as actual losses were peaking. That experience, coupled with a reduction in equity through the reserve build in 2008, would have resulted in higher returns.
The potential capital hit stemming from CECL adoption during the Great Recession could have forced some institutions to rebuild their equity balances during trying times, and those capital raises would have proved punitive. Capital levels are higher today, and losses in the next downturn are unlikely to match the levels seen in last decade's credit crisis, but some banks could find themselves with a capital hole as they implement the new accounting provision.
Regulators have proposed a rule that would allow banks to phase in CECL's capital hit for regulatory purposes, but that will not necessarily address capital in the eyes of the Street. During the credit crisis, tangible common equity was paramount for investors. Any bank operating with a thin capital cushion today might be wise to begin the capital planning process ahead of CECL implementation 18 months from now. Other banks with excess capital might want to take advantage of the new standard, heavily scrutinize their portfolios and substantially increase their reserves to prepare for the next downturn while they have the opportunity to do so without impacting their earnings.


