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'Double-count' CECL issue more significant for larger bank M&A

A new accounting standard will change how banks calculate deal metrics and will likely have a more significant impact on larger transactions. The issue has attracted more attention lately as chatter about potential mergers of equals is on the rise.

Bankers have referred to the issue as a "double-count" of the credit risk for non-purchase credit deteriorated, or non-PCD, assets. BB&T Corp. and TCF Financial Corp. lobbied the Financial Accounting Standards Board to take up this issue, which is part of the current expected credit loss standard that will take effect for most large banks on Jan. 1, 2020. But FASB declined on Sept. 18 to add the matter to its agenda.

Under the purchase accounting rules that govern bank mergers, the buyer has to mark acquired assets to fair value, a process that typically involves a credit mark. Separately, CECL requires the acquiring bank to build a reserve that would cover the expected losses over the lifetime of the loan. During the Sept. 18 meeting, FASB staff recommended the board decline to add the issue to the agenda since the relevant facts had already been debated. Board member Hal Schroeder agreed.

"Everything you've articulated was exactly what we spent I don't remember how many years debating, and I didn't hear a single new thing in there," he said.

Vice Chairman James Kroeker said he agreed with bankers that the treatment of non-PCD assets represented a double-counting. But he, too, said there was no new information to warrant taking up the issue. "I do believe there is a double-count, and I think that double-count exists whether it's acquired or originated," he said.

Kroeker's opinion appears to differ from the case laid out by BB&T and TCF Financial. The banks argued that CECL would treat non-PCD and originated assets differently. They said the standard requires a double-counting on expected credit losses for the non-PCD assets and "unnecessarily penalizes" the acquirer's equity.

Acquirers eventually earn back the credit mark on non-PCD assets through accretion income, meaning the main effect may be a matter of timing.

"I'm not sure it's a double-count, but it's definitely a change in how the credit risk is recognized by the acquirer," said John Donohue, a partner with accounting firm Moss Adams, in an interview. "Conceptually, CECL doesn't change the total amount of losses. It changes the timing, and with acquired loans, it's a little harder."

However, Donohue said CECL could increase volatility in dealmaking and introduce new risks. Since deals tend to take at least three months to close, a rapid deterioration in the economic outlook could require a drastically different level of reserves — and significantly more capital — at closing than had been expected at announcement.

"It is something to consider as part of their overall deal strategy and how much capital they maintain and how much of a buffer they think is appropriate. It definitely adds to your potential volatility," Donohue said.

While there is some disagreement as to whether the non-PCD issue represents a "double-count" of credit risk, it appears clear the matter will affect key deal metrics and that larger deals will see a more significant impact. In recent years, investors have become increasingly focused on earnback calculations, a measurement of how long it takes a bank to recoup any tangible book value dilution from a deal.

When First Defiance Financial Corp. and United Community Financial Corp. agreed to a merger of equals, executives said the non-PCD issue would roughly double the earnback period to 1.8 years. Without CECL, the earnback would have been less than a year, executives said. Christopher Olsen, managing partner for deal adviser Olsen Palmer LLC, said he expects more banks to report deal metrics with and without CECL to assuage market concerns over longer earnback periods.

"Savvy bank investors will know to differentiate and figure out what matters," Olsen said in an interview. "And it won't change the underlying economics or valuation."

Olsen and Donohue both said that the larger a target relative to the acquirer's size, the more significant the impact on earnback timelines. Ever since the BB&T and TCF mergers of equals announced earlier in the year, bankers have been talking about the possibility of additional transformative deals.

Kevin Parks, founder of investment firm Parks Capital Management, said he does not think CECL or the non-PCD issue would change merger decisions.

"If it makes strategic sense, they're going to do it. CECL, at the end of the day, is an accounting change," he said in an interview. "I don't think pointing to CECL as a reason for or against a deal is entirely genuine."