The change in the way U.S. financial institutions report and account for loan losses will have an unequal effect on U.S. banks’ capital levels. But the overall industry impact will be a decline in the aggregate Tier 1 capital ratio, according to S&P Global Ratings.
The Financial Accounting Standards Board’s new incurred loss methodology requires financial institutions to adjust for expectations of future lifetime losses from their loans, not just for past and present credit losses. U.S. banks will, therefore, need to keep additional loan loss reserves. That change could have “an immediate negative impact on capital ratios,” says S&P.
Although the accounting standard doesn’t take effect for publicly held banks that file with the Securities and Exchange Commission until January 2020, a few banks have already hinted at the accounting rule’s impact.
Citigroup, for example, estimated the loan loss accounting methodology would increase its reserves by 10% to 20%. JP Morgan Chase’s projection is even higher, at 35%. U.S. Bancorp expects a 20% to 30% increase.
In a hypothetical sensitivity analysis run by S&P, it found that a 10% increase in reserves industry-wide could slice 7 to 8 basis points off the aggregate Tier 1 capital ratio. Risk-adjusted capital ratios could fall by 5 to 6 basis points.
Of course, the effects won’t be evenly spread. Banks with riskier loans and loans of longer duration in their portfolios are more likely to take lifetime losses under the new standard, says S&P. Since consumer loans are a good proxy for longer duration loans (information on duration and risk not being publicly available), S&P estimates that institutions with consumer-heavy portfolios like Sallie Mae, Discover, Synchrony, Capital One, and American Express could be affected the most.
Banks with high loan-to-asset ratios could also be impacted significantly. In the data supplied by S&P, banks that fit that bill include Texas Capital, S&T Bancorp, TCF Financial, and Synovus. Synchrony, Sallie Mae, and Discover appear on both lists.
S&P does caution readers about its analysis: the macroeconomic environment matters, for example. And the more problem loans a bank currently has on its books, the less it will be affected by the new accounting methodology.
U.S. banks have sought to delay the implementation of what is officially called the current expected credit losses methodology (CECL), calling for a qualitative impact study to look at how it will influence lending and regulatory capital. They have also proposed an alternative way of provisioning for lifetime loan losses.
FASB has not indicated if it would consider either, but it is allowing financial institutions to phase the change in over a three-year period. S&P says this could mitigate the negative effect on any one bank.
Federal Reserve chairman Jerome Powell has said that the Fed has “tried to work with banks so that they’ll be able to implement this FASB decision in ways that are not too disruptive and too expensive and too complicated.”