Beginning in 2020, the Financial Accounting Standards Board (FASB) will require large financial institutions and smaller banks to estimate and report loan losses upon origination according to the Current Expected Credit Loss (CECL) standard, commonly referred to as the loan-loss rule.
In recent congressional testimony, JPMorgan Chase CEO Jamie Dimon charged the rule will constrain banks and stymie lending. Even more portentously, CECL does not work: a major conceptual error in FASB’s guidance will cause significant losses to be reported where none exist and could result in a further significant decline in lending, which in turn could exacerbate a potential recession.
The loan-loss rule requires, upon origination, recognition of credit losses using economic forecasts over the contractual lives of loans and held-to-maturity debt securities.
Heroic assumption
One can appreciate the salutary transparency the anticipation of losses required by the FASB rule can engender. Financial statements would become less opaque, duly warning investors about impending losses; this was the raison d’être of FASB to revisit the model for estimating loan losses in response to the financial crisis of 2008.
However, the rule would require a heroic assumption: reasonable accuracy in estimating losses over the very long term, such as 30-year residential mortgages and student loans, especially when attempting to predict cyclical turns.
Moreover, CECL goes overboard in requiring the recording of losses where none exist. This in turn results in an unjustified decrease in regulatory capital, and potentially reduced lending, especially during anticipated economic downturns, with draconian consequences for the economy.
The likely outcome of CECL is a very significant increase in artificial — not economic — loan losses, with corresponding adverse effects on regulatory capital. Applied to the $17 trillion banking industry, and a little above $15 trillion in mortgages alone as of the fourth quarter of 2018, this could spell disaster, leading to detrimental effects on lending and the economy.
The American Bankers Association, in its statement before the Financial Institutions and Consumer Credit Subcommittee of the House Committee on Financial Services, warned against some of the injurious effects of CECL: increased volatility of regulatory capital, the necessity of increased capital at all times, higher interest rates for borrowers and favoring shorter term loans over longer term ones including residential mortgages and student loans.
How the rule works
That is all true, but more fundamental is the grave conceptual error embedded in CECL: recording accounting losses in the absence of real economic losses.
Simply articulated, the standard ignores that lenders would rationally increase interest rates to compensate for whatever default risk and consequent non-payment of principal and/or interest they anticipate over the lifetime of the loan. Hence, they would expect not to incur any economic loss upon loan origination. Further, if over time they forecast a heightened default risk, in many non-fixed rate cases, they would increase interest rates again to make themselves whole. Yet, under the FASB’s guidance, they are required to report accounting losses in the absence of economic losses, decreasing regulatory capital. This perverse outcome is a result of FASB requiring the use of a discount rate that is the same as the stipulated loan interest rate.
To illustrate with a simple example, imagine you lent me $1000 to be repaid by me in a lump sum after three years with annual interest payments. If you anticipate I would not default and pay all amounts as stipulated, you would charge me a 10% interest. However, if you anticipate I would pay you back the full interest but only $900 at the end of three years on account of principal, you would charge me 13.0213% interest to compensate for the shortfall. Under FASB’s guidance, you would be required to use a discount rate of 13.0213% which would result in a reported loss of $69.27 — a substantial 6.9% of the loan you originated. (Absurdly, were you to apply FASB’s guidance to this example and yet show zero accounting loss, you would have to charge — and use as the discount rate – an interest rate of 4694%, reaping huge economic profits!). Departing from FASB’s guidance, however, a discount rate that equals the original loan rate of 10% would yield an accounting loss that is equivalent to the economic loss: precisely zero.
Clearly, this is a hypothetical scenario, but even if the reported loss were less than the approximately 7% of this example, when CECL is applied to huge amounts of originated loans, it would result in staggering fake losses. Consider the impact this rule would have on the $457 billion in mortgages (not considering other types of loans) originated in the country over just one quarter (the third quarter of 2018).
There is a simple cure to prevent artificial accounting losses: change the guidance so that the rate used to discount expected cash collections (both principal and interest) is not the stipulated loan rate but rather the internal rate of return, i.e., the rate that yields as present value the amount of the loan originally extended without incurring an economic loss. In my simple example, this would be the 10%.
With this cure, prudent lenders who properly price the loan will suffer neither an economic loss nor an accounting loss upon origination. Without this cure, the Alice in Wonderland accounting reflected in FASB’s CECL standard will result in lenders recording billions in non-economic artificial accounting losses impacting regulatory capital with consequent impact on lending and the economy generally. FASB and banking regulators should take note.
Joshua Ronen is a professor of accounting at New York University Stern School of Business and co-editor of the Journal of Law, Finance, and Accounting.
