Friday, April 14, 2017

Who is "Cecil"? What is "Cecil"?

As if they didn't have dozens of other issues to resolve, financial institutions must now incorporate new CECL rules when determining expected losses on credit portfolios.
In sports, commentators analyze "on field" activity and "off field" issues.  The game is played with veracity and intensity on the court, on the diamond, and in arenas. Yet off-field issues abound in levels as low as Little League all the way to the Olympics and the NBA.

In banking and finance, commentators and senior managers in financial institutions analyze both on-field and off-field issues. On the field, industry participants and observers wonder where fin-tech will take us and worry about the threats of "shadow banking" and cyber thieves. They explore opportunities to increase loan portfolios, trade securities, or invest in companies.  Off the field, they fret about the burdens of regulation and the future of Dodd-Frank and wonder how to reshape strategies to make money without liberties they enjoyed just a decade ago.

(In his latest message to shareholders--and for all purposes, to the entire financial community, JPMorgan Chase CEO Jamie Dimon used his annual forum to complain about how burdens and inconsistencies of bank regulation distract from his bank's efforts to grow, expand and be an engine booster in the economy. This year, however, he delineated specific examples (liquidity, capital, and leverage ratios) and called for immediate action to simply difficult rules.)

Financial institutions are encountering yet another off-field issue, and as 2020 approaches, they whisper and talk among themselves about its possible impact on earnings and precious capital calculations. It's called, informally, "Cecil."

Cecil stands for "Current Expected Credit Loss," or CECL, or "Cecil." It's not a Basel III, BIS or Dodd-Frank regulatory requirement, although bank supervisors happily endorse its purpose. It's a new accounting standard.

Financial institutions (banks, mortgage companies, finance companies, etc.) book loan assets, or assets with varying degrees of credit exposures and risks.  They may be leases, credit-card receivables, mortgages, or long-term loans to a Fortune 500 company. They may be corporate bonds held to maturity. They also project losses on the portfolio or anticipate defaults on delinquent, high-risk or non-performing assets.

Hence, for a $100 million portfolio of loans, accountants (with regulators in the background) guide lenders on how much they should reserve for losses:  loan-loss allowances, loan-loss provisions, etc. This total is not always based actual losses or actual charge-offs, but on "expected losses." Actual charge-off histories and losses figure in the determination, but reserve amounts are supposed to be a forward-looking calculation.

Banks determine these reserves or allowances in various ways, often prudently, carefully, and based on outlook in various markets.  But they do so inconsistently.  The reserves are subtracted from earnings and capital.  Traditionally banks don't want to make them too high or too low.

A year ago, financial institutions were examining their corporate loan portfolios for oil-and-gas exposures as plummeting energy prices jeopardized the payout of loans to related companies.  Across the board, because expected losses on these assets were increasing (because of troubles in the industry), banks increased their reserves.  Each bank decided what would be appropriate and did so under the auspices of accountants, regulators, competitors, counterparties, and shareholders. In such analysis, banks target the borrowers that would be candidates for losses:  vulnerable borrowers, borrowers on watch lists, borrowers in declining industries, etc.

Financial institutions spend substantial amounts of time discussing and analyzing what reserves should encompass or are meant to be. Should they be subtractions from delinquent loans, restructured loans, and loans that are candidates for charge-offs?  Should they take into account the probabilities of default or credit deterioration of even the best, investment-grade portfolios? And to what extent should loan recovery (the amounts that can be recouped after a loan defaults, typically because of collateral, seniority, hedges or guarantees) be incorporated?

Now comes Cecil to ensure this practice (a) is implemented more consistently across all financial institutions (not just banks), (b) proceeds with similar assumptions, and (c) examines the possible or expected losses for the entire life of the loan that is booked (not just for one year or two years).

What worries banks is "Cecil" may highlight where they may have been under-stating expected losses or allowances and may require them to increase loss provisions substantially.  As well, credit provisions (and annual allowances for customer default) will likely increase from year to year, become a much larger cost than usual, and diminish bank profit growth and capital build-up.


Big banks (like Citi, JPMorgan Chase and Bank of America) already take credit provisions on loan portfolios of $1-2 billion annually (higher in 2016 as they grappled with struggling energy exposure). Within those same portfolios, they have reserves for losses that can top $10 billion, a direct subtraction from gross loan portfolios.

Cecil rules will require banks (in 2020 and beyond) to calculate expected losses based on the entire life of a loan, not loss expectations over a shorter time frame.  The rules also apply to corporate securities that are held to maturity.

If Wells Fargo, PNC, Goldman Sachs or Regions books a $25 million, ten-year loan to a corporate client, then it must determine an expected loss based on 10 years, not one or two years. How much could Wells Fargo be expected to lose over a 10-year loan life? Under most scenarios, the expected loss over 10 years would be significantly higher than an expected loss over a year or two, if only because the elapse of time presents many scenarios for the borrower to default.

Basel III and Dodd-Frank require related calculations, but differ in two ways:  (a) Regulators require banks to determine losses over a one-year time frame, and (b) they want banks to hold capital (not apply provisions against earnings or allowances for default under loan assets) for unexpected losses.  They want banks to have capital to absorb the risks for the worst-case scenario over a much shorter period.

Just like Basel III rules, Cecil rules may have impact on the volume, content and riskiness of the loans banks decide to book in short- and long-terms.

Risk analysts define expected loss to be the product of probability of default x loss-given-default x exposure at default.  In the 10-year loan example, the probability of default is much higher over 10 years than over one year, because (a) default statistics show this to be true and (b) there are ample opportunities in 10 years for borrowers' creditworthiness to decline and market conditions to deteriorate. Banks can reduce expected losses by requiring exposures to be shorter in terms or requesting good collateral for even stronger borrowers.

Financial institutions still have about two more years to adopt approaches and a loan strategy.  They are doing this already as they determine concurrently the amounts of capital necessary for Basel III purposes.

Nonetheless, where it's now an imposing challenge for banks to achieve superb returns on equity (ROE) (say, above 12%), it could get harder.  For the same level of risks and business activity, Cecil could reduce ROE by a percentage point or two.

Banks might respond in many ways:

a) Focus on investment-grade borrowers and require collateral or some degree of support in ways they may not have required it before.

b) Reduce portfolio exposure with non-investment-grade borrowers, new ventures, or borrowers with little track record or operating in industries with no history.

c) Reduce exposures for longer tenors and focus on shorter-term funding arrangements.

d) Focus on products with revolving exposures (revolving credits) rather than long-term commitments.

e) Continue to sell off or securitize loan exposures beyond a certain threshold.

In other words, reduce the tolerance for risk, when there will, otherwise, be an immediate impact on earnings and returns.

For analysts, Cecil will make it easier to compare banks' loss provisions as apples to apples. For bank supervisors, it will be an additional tool to reduce the likelihood of another financial crisis.  But for banks, it will be another variable to manage precisely in what they perceive might be a vain effort to construct the almost-perfect balance sheet.

Tracy Williams

See also:

CFN: Wells Fargo's 2016 Woes, 2016
CFN:  The Essence of Corporate Banking, 2010
CFN:  Bank ROE's: Stuck at 10%, 2015

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