April 2, 2020 - The Federal Reserve, in a joint statement made on March 27th with the Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency, announced it would give banking organizations the option to delay an estimate of CECL’s effect on regulatory capital in their regulatory filings until 2022 due to COVID-19. The interim final rule, which takes immediate effect but is not mandatory for banks wishing to stay the course, applies to banks required to adopt CECL by its January 1 effective date this year. In addition, Lenders have three years to phase in any capital hits that would have taken place during the two-year delay. This rule goes beyond the $2 trillion stimulus package approved by the House and signed by the President, which included a provision giving large public banks a temporary delay in adopting ASU 2016-13 including CECL methods until the earlier of Dec. 31, or when the coronavirus public health emergency ends.
What does CECL do? With the incurred loss methodology, banks did not record losses until an event persuaded them that a borrower may not be able to make loan payments in full, relying heavily on historical data. The need for CECL originated during the financial crisis of 2008-09 when it became evident that financial instrument and accounts receivable impairments needed to be addressed. FASB determined that the new accounting model should estimate the potential expected loss from the origination of the instrument with such estimates based not only on historical data and current conditions but also foreseeable future economic losses. This translates to at least some loan loss reserve being recorded on the balance sheet from the origination of the loan. Today, the switch to CECL would most likely result in a significantly increased amount of cash that banks would need to set aside to cover impaired loans thereby cutting into banks’ regulatory capital. This extension of the transition period from the current method to CECL should help to maintain the quality of regulatory capital and enhance the bank’s ability to continue to lend as the overall goal of the delay is to be able to meet the future demands for loans.
The question for all will be how to reasonably reflect the potential effects of COVID-19 in estimating current expected credit losses given our world of diverse long-term forecasts regarding potential recession and ultimate recovery. Plus one must forecast how additional stimulus packages and other government actions will be reflected on an industry by industry basis.
It is safe to assume that the large financial institutions had CECL models and system tests with methodology and documentation in place to implement CECL this quarter. It will be interesting to see going forward if and how those models and assumptions are affected by COVID-19. The agencies are permitting banks to early-adopt CECL for the reporting period ending March 31 should they desire to do so; however, ready or not, there is little doubt that they will avail themselves of the relief the extension has provided.