Fitch Ratings will treat the implementation of the new loan loss accounting methodology as a credit-neutral event, according to a Jan. 24 report.
The adoption of the current expected credit loss model, or CECL, is "broadly" expected to be credit neutral and not result in initial ratings actions. CECL's adoption is largely expected to cause a decline in shareholders' equity and a corresponding increase in loan loss reserves as banks book lifetime losses for all their assets. Fitch issued the report after receiving numerous questions from issuers asking what a potential decline in capital needed to increase the allowance could mean for ratings, Michael Shepherd, associate director of financial institutions, said in an interview after the report was published.
Fitch wrote that banks' fundamental creditworthiness and their underlying loans will "remain unchanged" at adoption, with "no effect" on the timing or realization of cash flows. However, CECL's longer-term impact on ratings is "unclear" and will depend on how banks respond to and operate under the loss accounting requirements.
Fitch believes that CECL's initial adoption will increase loan loss reserves on the "lower end" of its previous $50 billion to $100 billion estimate for the entire banking industry. The authors said they came to that conclusion after revisiting the assumed loan durations, but added that the treatment of credit cards under CECL remains unknown. The report said the initial adoption could also reduce the system's tangible common equity ratios by 25 to 50 basis points in aggregate, but Fitch believes that impact could be on the lower range as well.
Shepherd said banks with between $10 billion and $250 billion in assets may "slightly" lower their capital levels at CECL adoption. But that may not factor into ratings as much because it remains "loss-absorbing capacity" for the bank.
"If this is the way they get [lower capital levels], by reducing it through a higher allowance, that's a little bit more credit-friendly than a share buyback or special dividend," he said.
The report said CECL could cause "unintended consequences" if implemented in its current form. Fitch believes that banks could be "unwilling or unable" to lend during periods of economic stress because of pressured earnings or capital ratios, which could constrain a recovery. They may also become reluctant to extend credit in times of stress, given that they will need to book the lifetime losses upfront — arguments others in the industry have made to the accounting board and regulators.
"The whole point of CECL is meant to reduce some of the procyclicality that probably existed under the current approach, where reserves go up really high during economic stress and then they come back down significantly during very good periods," said Christopher Wolfe, managing director of North American banks at Fitch, in an interview. "The question we have is '[Does] booking reserves upfront for all loans in a period of economic stress create a disincentive for banks to even originate a loan? Does that create or prolong an economic downturn?'"
Fitch also believes that earnings volatility under generally accepting accounting principles will increase under CECL because banks will need to incorporate economic forecasts that use a longer time horizon than the current methodology.