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Q4'19 earnings reports could be first test of volatility under CECL

U.S. banks are poised to report their first numbers under overhauled accounting rules in upcoming earnings reports, and analysts, investors and lenders face a difficult learning process as they transition to the new system.

For about a year, banks have been giving estimates of immediate, one-time changes to loss reserves under the current expected credit loss standard, which requires that lenders make set-asides for anticipated lifetime losses. Banks have also offered commentary about what ongoing provisioning will look like after the Jan. 1, implementation date, although without delivering specific, numeric guidance. Substantial differences between estimates and actual one-time allowance adjustments could serve to confirm widespread expectations that provisioning will be more volatile going forward.

More broadly, market participants will be working to make sense of a torrent of new information. Banks will be looking to peers to see what decisions they made in choosing models and setting economic assumptions. Investors and analysts will have to sort through the different approaches to understand how to compare banks, and how to interpret new dynamics under CECL, where healthy growth could simultaneously generate stiff credit costs as lenders book reserves up front.

A window on volatility in ongoing provisioning

"The first question will be the actual number — how do you reconcile that with what your previous disclosures were?" Thomas Barbieri, a partner at PwC who specializes in CECL, said in an interview. "What changed and why? Was it due to changes in assumptions at year end relative to [when the estimates were established]?"

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All banks with more than $50 billion of assets have provided estimates on CECL's immediate impact, with most projecting that they need substantial "Day 1" increases to allowances to make the transition from the previous system, under which they were required to reserve for probable losses over a shorter time frame. Some banks have reiterated earlier estimates or narrowed the range of previous forecasts. Bank of America Corp. bumped up its expected increase in its allowance to 30% from 20%, attributing the move to changes in its models and certain loan sales.

Banks have said that provisioning will be more volatile under CECL in part because projections for lifetime credit losses could swing when economic assumptions shift. Differences between the Day 1 estimates banks gave before implementation and the actual transition adjustments they record could provide some perspective on such volatility, if they are driven by real "changes in the underlying economic environment," Barbieri said. However, he observed that changes to models and portfolio mix could also drive deviations, making the matter less clear.

The details of CECL disclosures will matter enormously for this reason, and for banks seeking to compare their own approach against competitors. "Many financial institutions will want to gain more insight into what others are doing in establishing reserves," Barbieri said.

Investors will also be combing through the specifics of the disclosures. "Because not everybody is going to have the same forecast, it's going to result in variability across firms that may be hard for investors to interpret if the firms don't provide sufficient clarity in terms of what their economic forecasts are," Moody's Senior Vice President David Fanger said in an interview.

A check on forecasts for future credit expenses

Bank guidance and disclosures will also provide a check on market expectations about ongoing credit costs, which analysts expect to tick up as companies set aside for growing portfolios at generally higher allowance ratios.

In a Jan. 6 note, analysts at UBS said they anticipate that provisions at large banks will move up modestly, but that CECL implementation is "consequential."

"CECL could add volatility, along with raising questions about earnings quality and comparability," the UBS analysts said. "Inflections in credit cycles are also likely to be factored into loan loss provisioning much more quickly than under the incurred loss model."

Analysts at Keefe Bruyette & Woods gave a similar warning. "There is a risk that the ongoing impact is larger than expected and this can create investor concern, as earnings misses on provisions are not well received by the market given one-off credit concerns have been rising," they wrote in a December 2019 note.

Insight into potential changes in product design

As banks acclimate to the new accounting regime, markets and competitors will also be monitoring executive commentary for additional clues on potential changes to loan design and mix.

The tangible impact of CECL on competition and the way businesses are run is "a big unknown at this point," Barbieri said.

Projections for large increases in reserves have been driven heavily by long-duration consumer portfolios, and banks like Citizens Financial Group Inc. have been candid that they would consider pulling back on certain longer-term loans.

During a presentation in December 2019, Regions Financial Corp. CFO David Turner underscored CECL's impact on long-dated assets. "The industry is going to be learning a little bit this year in terms of what that might mean strategically to us all," he said. "This year will be a learning year."

At the same conference, Wells Fargo & Co. CFO John Shrewsberry said his bank has done a product-by-product review to see if changes to terms and prices are warranted under CECL, but that for the most part the accounting standard on its own would not prompt Wells Fargo to reprice or exit a product.

"A lot of people would say [lending is] driven by economics and the economics aren't changing," said Peter Nerby, another senior vice president at Moody's. "But I think we'll see."