“We know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don't know we don't know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.”
- Donald Rumsfeld, February 12, 2002
What Donald Rumsfeld called the “unknown unknowns,” Nassim Nicholas Talab called the black swan. Recognized for decades, these transformational events have three critical characteristics:
- Unpredicted and unknowable by the vast majority of people or models;
- Enormous and lasting impact on our economy and society;
- In hindsight, completely predictable as proven by a few outliers (e.g. Bill Gates in 20151 ).
For this generation, COVID-19 is our unknown unknown, our black swan. For the lending community, this will assess our ability to service our clients, manage our risk capital and communicate new economic lifelines from the federal government all within a dramatically altered work-at-home environment. We will be tested.
Coincidentally, this year FASB also rolls out the most radical transformation of loan loss accounting in fifty years. Known as the Current Expected Credit Loss or CECL, this new standard requires lenders to project future credit losses for the entire lifespan of their loans using historical data adjusted by experience. For most lenders with any public filing and a December 31 year end, the first filing will be due as of March 31, 2020: the heart of our pandemic.
In this market commentary, we will describe why the accounting, regulatory and legislative responses to COVID-19 and CECL will be insufficient alone to sustain many lenders. In a following part 2 of the market commentary, we will describe why existing loan loss and capital models need to be rethought. We will also offer an alternative for the future which is more appropriate for lending in an unknowable world.
CECL Moves Forward
FASB is moving forward with its CECL implementation timeline despite concerns expressed from industry, regulators and legislatures2. Their reasoning is threefold:
- Cost and confusion: The substantial CECL investment already made to systems and investor communication by banks would be wasted and would create investor confusion;
- Investor harm: CECL more appropriately matches revenues to expenses in real time and “provides greater clarity on the actual risk profile” of a bank; and
- Regulatory relief: FASB argues that regulatory capital relief can and will be provided to depositories regardless of the GAAP accounting.
While most banks subject to the 2020 deadline have an implemented and tested CECL solution, no system can be ready for the impact of COVID-19. Models are based on data, experience and calculations. In this case, there is little to no historic data to inform us about future default performance or collateral value behavior. Calculations will require adjustments to account for massive exogenous forces from government as well as shutdowns. Experience will become increasingly important with “out-of-the-box” thinking around borrower behavior and chain dependencies becoming most valuable. The interaction of these complex new parameters, as well as an evolving view for whether a sector recovery is V-shaped, U-shaped or L-shaped, may determine lender solvency in a post COVID-19 CECL world.
Regulatory Response is Constructive, but Insufficient
In response to this need, joint federal agencies3 took substantial action to delay the regulatory impact of CECL.
Most prominently, on March 27th the agencies updated their Interim Final Rule (IFR) regarding CECL implementation to allow a two-year extension for banks to file their estimation of CECL’s impact4. This two-year extension applies only to banks previously required to file as of January 1, 2020. It is also in addition to the 3-year phase-in period already in the 2019 CECL IFR, effectively creating a 5-year phase-in period. This regulatory relief is also optional since the agencies acknowledge that many banks have already transitioned to a CECL framework and going back to the legacy incurred loss methodology would create new systems, process and people expenses.
Despite the substantial regulatory capital relief provided by agencies, CECL capital compliance remains a mandated challenge for any lender filing GAAP statements. Regardless of regulatory relief, any bank filing public or private statements under U.S. GAAP will still require loan losses to be capitalized using the new CECL methodologies. Lenders may continue to run parallel reports using legacy incurred methods for regulatory capital, but this will be a resource challenge for lenders and a source of confusion for investors.
FDIC Chair, Jelena McWilliams, recognized this hurdle when publicly sending her March 19 letter5 to FASB expressing concerns over maintaining CECL compliance. She noted that continued economic volatility could result in higher credit allowances than those initially anticipated. Further, rapidly evolving economic uncertainties stemming from the pandemic, combined with unprecedented actions taken to mitigate these effects, has the potential to make some allowance assessment factors less reliable.
McWilliams also expressed concern that some current assessment factors could reduce lender flexibility when it comes to working with credit-worthy borrowers who have been impacted financially by the pandemic. Under CECL, any modifications to terms could be considered “a concession when determining a troubled debt restructuring (TDR) classification, negatively impacting the bank.”
In her view, holding lenders to CECL transition standards at this time would also hinder a lender’s ability to serve depositors and meet the credit needs of customers and members. In addition to the unprecedented challenge of supporting remote work environments while effectively serving customers, banks and credit unions are also addressing “the earnings and capital implications of near zero percent interest rates.”
Given the circumstances, McWilliams urged FASB’s Acting Technical Director, Shayne Kuhaneck, to allow those financial institutions currently undergoing the CECL transition process the option to delay final compliance. She also called for a compliance moratorium for all financial institutions subject to the January 2023 implementation date, to provide them with the time and resources necessary to serve customer and member needs during the COVID-19 pandemic.
Implications, Impact and Next Steps
As we discuss in part 2, FASB’s governing board refused to relinquish its CECL standard, leaving lenders with the burdens of reporting CECL capital for all GAAP statements regardless of regulatory relief. The implications for technology platforms and models are stark – and unknown unknowns continue to be an everyday reality.
1 Bill Gates Ted Talk, March 2015, The Next Outbreak: We’re Not Ready, https://www.ted.com/talks/bill_gates_the_next_outbreak_we_re_not_ready?language=dz
2 March 23, 2020 letter to Congress from Kathleen Casey, https://d2l6535doef9z7.cloudfront.net/Uploads/x/p/b/fafletter_846416.pdf
3 Collectively known as the “joint agencies” for purposes of this paper, these are the FDIC, the OCC and the Federal Reserve System (including its member banks)
4 The new CECL IFR can be found here: https://www.fdic.gov/news/news/press/2020/pr20041b.pdf
5 FDIC letter to FASB found here: https://www.fdic.gov/news/news/press/2020/pr20036a.pdf
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