FASB Proposes to Replace the “Probable” or “Incurred” Thresholds for the Allowance for Loan and Lease Losses Under U.S. GAAP With an “Expected Credit Loss” Standard: Potential Impact on Bank Reported Earnings and Capital and on Regulatory Capital Ratios
On December 20, 2012, the Financial Accounting Standards Board (the “FASB”) issued for public comment a Proposed Accounting Standards Update, Financial Instruments – Credit Losses (Subtopic 825-15) (the “Credit Loss Proposal”), that would substantially change the accounting for credit losses under U.S. generally accepted accounting principles (“U.S. GAAP”). Under U.S. GAAP’s current standards, credit losses are not reflected in financial statements until the credit loss is probable or has been incurred. Under the Credit Loss Proposal, however, an entity would reflect in its financial statements its current estimate of credit losses on financial assets over the life of each financial asset. Comments on the Credit Loss Proposal are due by April 30, 2013.
The Credit Loss Proposal, if adopted as proposed, is likely to have a negative impact on U.S. banks’ reported earnings and capital and on regulatory capital ratios, as well as on regulatory limitations based on capital (e.g., loans to affiliates). This is a result of larger loan loss reserves being required at an earlier date. It could also have a procyclical impact on lending because higher reserves would seemingly be required at the inception of a loan if recent loan loss experience on a portfolio basis had increased and conversely lower initial reserves if recent loan loss experience had declined.
THE CREDIT LOSS PROPOSAL
The Credit Loss Proposal is an outgrowth of concurrent projects of the FASB and the International Accounting Standards Board (the “IASB”) to address the perception of both Boards that, during the financial crisis, the “overstatement of assets caused by the delayed recognition of credit losses associated with loans (and other financial instruments) . . . [was] a weakness in the application of existing accounting standards.”1 In May 2010, the FASB issued a Proposed Accounting Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities (the “2010 Update”), designed to address this concern by moving to an “expected loss” standard but requiring entities to assume that economic conditions existing after a reporting date would remain unchanged for the remaining life of the financial assets. As compared to the 2010 Update, the Credit Loss Proposal would broaden the information an entity is required to consider in developing its credit loss estimate to be forward-looking and include, among other things, potential changes in economic conditions.
Subsequent to the 2010 Update, the FASB and IASB had worked together on a model for addressing credit losses that would utilize two different measurement objectives of the credit impairment allowance, with an entity identifying:
- one subset of its portfolio of financial assets upon which a loss event is expected in the next twelve months and for which it would recognize lifetime expected losses; and
- another subset for which a loss event is not expected within the next twelve months and for which it would separately recognize lifetime expected losses.
In contrast, the Credit Loss Proposal would have a single measurement objective as outlined above – that is, a current estimate of expected credit losses on financial assets over the lifetime of each financial asset.
The Credit Loss Proposal would not change U.S. GAAP’s “geography” for reflecting credit losses in financial statements. Changes in expected losses would still be reflected in the income statement by a loan or credit loss provision and, on the balance sheet, as a contra asset reflected as an adjustment to total loans or other relevant financial assets (albeit labeled as the “allowance for expected credit losses” as opposed to the current label of “allowance for loan and lease losses”). Reductions in income would, of course, affect capital.
Items of note in the Credit Loss Proposal include:
- Covered Financial Assets. The financial assets covered by the Credit Loss Proposal include most debt instruments (whether classified at amortized cost or at fair value with qualifying changes in fair value recognized in other comprehensive income), reinsurance receivables, lease receivables and loan commitments that are not unconditionally cancellable.2
- Standard for Estimate of Expected Credit Losses. An entity’s allowance for expected credit losses on financial assets at each reporting date is specified to be its “current estimate of all contractual cash flows not expected to be collected.”3 The Credit Loss Proposal specifies that an estimate of expected credit losses is to be based on both internally and externally available information that includes
“information about past events, including historical loss experience with similar assets, current conditions, and reasonable and supportable forecasts and their implications for expected credit losses,” including “quantitative and qualitative factors specific to borrowers and the economic environment in which the reporting entity operates.”4
The discount rate utilized for each financial asset is that asset’s effective interest rate as opposed to a market rate as of the reporting date.5
- Scenarios for the Estimate of Expected Credit Losses. The Credit Loss Proposal provides that the estimate of expected credit losses “shall neither be a worst-case scenario nor a best-case scenario,” but rather shall reflect “both the possibility that a credit loss results and the possibility that no credit loss results.”6 Although the Credit Loss Proposal goes on to state that a probability-weighted calculation of multiple outcomes is not required, it does not address how the standard would be met without a probability-weighted calculation.
- Assets Carried at Fair Value. Under the Credit Loss Proposal, an entity would not be required to recognize expected credit losses for financial assets measured at fair value with qualifying changes in fair value recognized in other comprehensive income (loss) if two tests are met: (i) the fair value of the individual financial asset is greater than or equal to the amortized cost amount of the financial asset; and (ii) the expected credit losses on the individual financial asset are insignificant.7 For financial assets measured at fair value that do not meet those tests, the Credit Loss Proposal specifies that the estimated expected credit losses is a contra-asset that reduces the amortized cost of the asset, with the net amortized cost amount (that is, the amortized cost net of the allowance for expected credit losses) being included on the balance sheet.8
INTERPLAY WITH BANK REGULATORY REQUIREMENTS
Regulatory Capital. It will be important for entities that are bank holding companies or banks (together for purposes of this memorandum, “banks”) subject to the U.S. banking agencies’ regulatory capital requirements to monitor and evaluate the Credit Loss Proposal’s impact, if implemented, on regulatory capital. Items to note in this regard include:
- Existing regulatory capital requirements permit banks to include in Tier 2 capital the general (as opposed to specific) allowance for loan and lease losses up to 1.25% of total risk-weighted assets. The Basel Committee’s revised capital framework, known as “Basel III”, includes the same standard. There has been no specific suggestion by U.S. or international bank regulators that this standard will change in response to accounting changes in the treatment of credit losses, although both U.S. and international bank regulators have indicated that they will monitor the impact of accounting changes on regulatory capital standards. Absent any change, the transfer from capital to the allowance for expected credit losses effected by the Credit Loss Proposal will reduce total capital as well as Tier 1 capital and Tier 1 common.
- So-called “advanced approaches” banks – that is, those with more than $250 billion in total consolidated assets or $10 billion in foreign exposures – are required under the advanced approaches risk-weighted capital rules to calculate expected credit losses for purposes of those rules (generally as the product of the probability of default, or “PD”, and the loss given default, or “LGD”). If a bank’s general allowance for loan and lease losses is less than its expected credit losses as calculated under the advanced approaches rules, the bank must deduct the shortfall 50% from Tier 1 capital and 50% from Tier 2 capital; if the general allowance for loan and lease losses exceeds expected credit losses, the bank may include the excess in Tier 2 capital to the extent that the excess does not exceed 0.6% of the bank’s credit risk-weighted assets. There is no indication as to how these expected credit losses will relate to the expected credit loss standard proposed by the FASB. It will be important for advanced approaches banks and the regulators to address the interplay between the calculation of expected credit losses under those rules and under U.S. GAAP if the Credit Loss Proposal is implemented.
- Banks that are required to submit capital plans under the Federal Reserve’s capital plan rule9 or stress tests under its recently implemented stress test rules pursuant to Section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act10 will need to evaluate the interplay between the base, stressed and severely stressed scenarios used for purposes of those rules as compared to the scenarios used for purposes of calculating expected credit losses under the Credit Loss Proposal if implemented.
- The FASB notes that certain types of entities may be able to leverage their current risk-monitoring systems in implementing the Credit Loss Proposal’s approach, noting specifically regulatory risk ratings, both internal and external, used by or applicable to banks.11
- Regulatory Review of the ALLL. In recent years, the bank regulators have become much more proactive in evaluating and criticizing both individual bank loan loss reserves and the methodology used in establishing those reserves. The complexity and uncertainty of the new proposed standard could create further strain between banks and their regulators in this area.
- Dividend Capacity. Because the bank regulators limit dividends and stock repurchases based on earnings, any reduced earnings resulting from the Credit Loss Proposal will constrain dividends.
- One-Time Cumulative-Effect Adjustment. As discussed below, it appears that the Credit Loss Proposal would be retroactive, with a one-time cumulative effect adjustment to be made upon its effectiveness. This could significantly affect capital (but, presumably not income). Questions will arise as to whether banks must include the potential adjustment in their capital planning exercise and public disclosures.
The Credit Loss Proposal does not specify an effective date. Instead, it provides that the FASB will establish the effective date when it issues final amendments. It goes on to specify that a financial entity impacted by the proposed amendments would record a “cumulative-effect adjustment to the statement of financial position” as of the beginning of the first reporting period in which final amendments become effective.”12