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PCBB Banc Investment Daily September 14, 2016
Banc Investment Daily
September 14, 2016

No Reason For Fear

People are certainly weird critters. Many of the banker variety sadly suffer as well from a horrible dual-affliction known as metathesiophobia and tropophobia. While we have heard some brightly colored pills may help with these issues, we would bet those medications may also have crazy side effects - like loss of hair or cause gas and bloating perhaps. Maybe it is just easier if bankers get over their fear of change (metathesiophobia) and fear of getting moving (tropophobia).
That's right - we are talking about the recent change in the way banks will have to estimate allowances for credit losses under the current expected credit loss methodology (CECL).
As we said above, people hate change, so given how new CECL is the natural tendency is to gripe about it to anyone who will listen. After all, implementation of the standard is still a few years out, so griping is certainly in vogue right now. We want to reassure you that we have looked at this issue closely and CECL is not as scary as it's being played out.
For starters, the new standard requires you to think about what your losses will be over the life of your loan portfolio. That is a change from what we all do now which is to set aside what you're going to incur over the near term. That change sounds scary and like a whole lot of work when you look at it in a vacuum.
However, the impact of this change will be mitigated. This is because the average life of a loan portfolio at a typical community bank is about 2.5 to 3.0Ys. So, average losses incurred over this time interval should be about what we have historically maintained in our allowance for loan and lease losses (ALLL). Ta-da!
Indeed, looking at FDIC call report data back to 1992, we find reserves and charge-offs (assuming an average loan life of 3Ys) were in sync with the exception of the Great Recession. In short, this was an exceptionally abnormal event by definition.
Next, if you are concerned about how to actually measure the life of a given loan, just knock on your CFOs door. He or she already has this information because they have to for asset-liability committee (ALCO) analysis. This analysis also includes the impact of changing rates on prepayment optionality.
Basically, bankers need to know how loan balances will decline over time, in order to apply the applicable loss rates to these declining balances. Put another way - this just means that different areas of your bank (lending and finance) are going to have to talk to one another more to get the information necessary to calculate the reserve under CECL.
Lastly, it's been bandied about that bank reserves might need to go up by 30% to 50% as a result of CECL. We believe as things stand now this is hooey. We say this because as previously noted banks have been over-reserving under the current rule for a long time. This is because qualitative considerations (Q factors) and unallocated reserves have made up the majority of ALLL for most bankers as they strive to account for "uncertainty". Given that CECL will "account" for some of this uncertainty with life-of-loan and forward-look components, much of the qualitative and unallocated reserves will need to be substantially dialed-back. While no one knows for sure yet, these may all offset each other.
For all these reasons, banks don't need to panic or resist this change. While your bank will undoubtedly have to adjust to the new accounting approach, in our view you shouldn't feel the need to take a pill to deal with a case of metathesiophobia or tropophobia.