New Accounting Plan Goes Too Far, Banks Fear
Bankers are raising concerns that a new Financial Accounting Standards Board proposal that would allow banks to set aside reserves for future losses is too open-ended and might result in banks putting too much aside.
Financial institutions and their regulators have battled for years with the accounting standards entity over the proper way to move away from the pre-crisis requirement that banks set aside reserves only when a loss had already been incurred on a loan. The goal has been to achieve an "expected-loss" scenario that lets banks look into the future in setting such reserves to avoid the kind of financial whiplash that occurred during the crisis.
Although FASB ostensibly moved closer to that goal this week, issuing a proposal on Thursday that would move toward such a model, the industry now fears it might have gone too far, forcing banks to reserve for expected losses over the entire life of a loan.
"If the interpretation by the regulators or the audit firms is life of loan, then it's going to become very, very punitive," said Raj Mehra, chief financial officer of Middleburg Bank in Virginia.
The latest proposal is a move forward by standards-setters to bring international financial accounting in line with 21st century credit markets.
But the process hit a significant snag over the summer when FASB pulled away from agreeing with the International Accounting Standards Board on a common approach to loss-reserve accounting. Many in the U.S. were concerned IASB's method was too complicated, did not reflect the accounting needs of a U.S sector with so many community banks and a requirement that only allowed a one-year projection period. Regulators and industry representatives feared that such a short time-frame could force some institutions that had been projecting further out would have to reduce their loss allowances.
But rather than propose a longer period, FASB's proposal did not suggest a time threshold at all. Under the proposal, institutions would be required to write down assets based on the historical performance of similar assets, current economic conditions and "reasonable and supportable" predictions about future events that could affect the asset's performance.
"An estimate of expected credit losses would always reflect both the possibility that a credit loss results and the possibility that no credit loss results," the proposal says. "Accordingly, the proposed amendments would prohibit an entity from estimating expected credit losses solely on the basis of the most likely outcome."
The proposal is also being interpreted as expanding the types of assets included in the new accounting model, which might force community banks to include their debt securities.
To a certain extent, bankers and industry representatives praised FASB's step, saying the approach was simpler than the model previously discussed with international accounting officials and that it clarified issues such as accounting for purchased credit-impaired loans.
"We think it's a good first step," said Mike Gullette, vice president of accounting and financial management at the American Bankers Association.
But as soon as FASB released the plan, some suggested it could force banks to complete forecasts about expected losses over time periods longer than they are currently equipped to handle.
"The proposal appears to require banks to extend some estimates of losses so far into the future that reliability will likely be called into question," Bob Davis, the ABA's executive vice president for mortgage markets, financial management and public policy, said in a statement Thursday.
Gullette said U.S. bank regulators will have to weigh in on what is the acceptable time threshold.
"If you take it to be a strict life-of-loan allowance for all loans you run into a problem," he said. "Bankers have proved that forecasting losses much more than a year or 18 months is very challenging because it requires forecasting of borrower performance, interest rates and other economic conditions.
"It would be really difficult potentially to have to project losses that far out in the future."
Peter Stickler, the chief financial officer of Inland Bancorp in Oak Brook, Ill., said the 12-month forecasting period discussed this summer was inadequate to include potential volatility in the market. But an open-ended period has its own perils.
"You should be looking ahead over multiple economic cycles, but the concern is if the period is not clearly defined it gives the regulators an open book to say institutions need bigger reserves," he said.
Others said banks may be worried about FASB turning one of the industry's historical worries about accounting requirements into a reality.
"Their real concern could be that this is a slippery slope towards measuring loans at fair value, which they have always strenuously opposed," said Thomas Selling, founder of Grove Technologies, LLC, and publisher of the Accounting Onion blog.
Meanwhile, the inclusion of all debt securities in FASB's proposed accounting method could pose its own problems.
"It's going to be a big change for community banks" setting reserves for debt securities, said Mehra. "The methodology would have to be changed. Infrastructure would have to be built."
"Under [Generally Accepted Accounting Principles] you don't reserve for expected losses for debt securities, but under this FASB proposal you have to reserve for expected losses on all debt securities. The challenge there for us is unless you have a government-guaranteed security you have to really figure out the methodology for those expected losses."
He noted that a common security held by community banks are municipal bonds, but institutions may lack the required information needed to provide long-term loss forecasts of such bonds.
"Municipalities that issue bank-qualified debt tend to be very small issuers and don't often post financial statements in a timely fashion," Mehra said. "If we don't have timely information to evaluate the health of the issuer and their credit risk because the information is not available, that's going to be a challenge."