With Deutsche Bank stock being pummeled this morning (down 6%, with a price to book of 0.39!), I suspect there are going to be some busy risk management folks today).
If you are in the business of delivering products/solutions/services to help banks and credit unions understand, quantify, and manage risk, congratulations. The next three years are going to be some of the busiest and most lucrative ever because all U.S. banks and credit unions must be compliant with a new accounting standard/framework by 2020/2021 (depending on the type of financial institution) -called Current Expected Credit Loss (CECL). There has been steady consolidation in the banking sector since the Global Financial Crisis (GFC), but the total number of institutions remains an epic 11,000 (ish). My inner sales person is salivating at the opportunity. Those of you that have been following this site for years know I am passionate about banking system risk, so my inner quant is excited to see a widespread implementation of a new risk management paradigm that will make the system safer.
The Big Risk
Before I lose some of you with a walk through of CECL, I want to remind you of what I have been writing about for years and consider one of the greatest risks to the sustainability and stability of the global economy: debt relative to GDP. For this article I’m going to spin the table. Your debt is an asset to a bank. So as debt has slowly gobbled up the U.S. economy over the past several decades, we’ve seen the size of banking system assets gradually grow to reach the point where they are now effectively the same size as the economy.
There are many implications to this chart but let me suggest the most important is the next recession will likely be associated with a banking system shock that will be devastating to the economy (and stock market) because the banking system represents a larger portion of the economy than ever. The recession of 2001 was associated with the stock market crash of 2000-2003. The recession of 2007-2009 was associated with the crash of the same period. In 2007 the banking system relative to the size of the economy was 50% larger than it was in 2001, so it should not have come as a surprise that the crash was faster. In the 7-year stretch leading into the GFC the banking system saw its loan book (assets) grow 85% while its loan loss provisions only grew 21%. A new and improved method of quantifying and managing banking system risk has been needed.
Side note: both crashes were stopped by new and more desperate levels of monetary policy actions. After years of monetary policy actions stopping crashes and making recessions smaller than they otherwise would have been, I present this very inconvenient chart of M2 money velocity. Those of you that took a few economics courses recall that GDP = money supply X velocity of money. But you may not know that as velocity of money slows, monetary policy tools become less effective. This explains why monetary policy actions have had to be more frequent and larger. Let me also suggest that when the next recession shows up (and we’re now flirting with the longest stretch of time without a recession), monetary policy tools will be less effective per unit ($) than ever.
Here’s what central banks spent to stop the last crash -and several crash initiations that barely started over the past few years. Somehow these balance sheets will be unwound over the next couple decades.
In the wake of the GFC, the Financial Accounting Standards Board -FASB- and its international counterpart- the IASB- began working on new accounting standards that would allow banks to better manage their balance sheet in good times and bad, and in so doing become less susceptible to recessions, credit crunches, and liquidity crises. In December 2012 FASB proposed CECL. This would be followed up by the IASB proposing their own expected credit loss version in 2014 for non-U.S. banks -called IFRS9. This is where things get interesting. FASB’s CECL regs are effective in January 2020/2021, but the IASB’s IFRS9 regs went live in January this year.
To be thorough, there was an important predecessor to CECL — an amendment to FASB 157 that was made in the peak of the GFC on March 17 2009. This amendment changed accounting for financial assets from mark to market TO mark to model. With this accounting rule change, systemically important U.S. banks were suddenly deemed solvent because their toxic assets trading at 10 cents on the dollar would now be treated as assets worth far more. Though viewed by many as arcane, this accounting rule change did as much as the Fed’s QE1 program to build confidence in the global financial system, ending the GFC and sowing the seeds for the economy to begin bouncing back. It also introduced the concept of mark to model accounting, from which CECL and IFRS9 would emerge.
Currently (pre CECL) we have an incurred loss model whereby losses have to be recognized over a 12 month period. Granted, there is a little wiggle room in terms of adjustments for qualitative and environmental factors. With CECL there is no longer a triggering event for credit losses to be recognized. Instead, credit losses will be recognized over the life of the loan according to a model for expected credit losses based on past events, current conditions, and reasonable and supportable forecasts. This new framework will likely result in larger allowances for credit loss reserves, making the banking system more safe, but otherwise less profitable for banks since every dollar of loan loss reserves depletes funds available for new loans or dividends.
To bankers, this note:
CECL requires modeling and forecasting abilities, and a forward looking mindset to credit loss management that will cause a sizable change to operations and management. Not least, your team will have to develop, adjust, and maintain a set of macroeconomic forecast models. These models will have to incorporate cyclical and secular mean reversion trends, and adapt to spurious central bank actions. With these models will come forecasts for loan pre-payments and forecasts for the impact of adjusting your exposure to assets like HELOCs and other unconditionally cancellable assets. It’s all about having a formal and rigorous process for forecasting future loss allowances and how you make provisions for impairing these assets.
CECL will have dramatic effects on how banks manage data. It will place more pressure on banks to have clean data because much more modeling will need to be done. It will also force banks to streamline data across silos and be more granular. Data will have to be integrated across business units and functions. Loss forecasts are going to have to be regularly if not continually adjusted. In some cases, daily. As a result of this, you’re going to have to have more integration and automation of processes, and dramatically enlarged capacity to collect, normalize, and analyze data. Having clean data and adaptable models is a great start. But what regulators want to see -and what you’ll need to have- will be rigorous, methodical, scalable, automatable processes. On your plate will be demands for short turn arounds that will frequently require several iterations to respond to a dynamic environment that keeps impacting the macroprudential assumptions in your models. Your CECL framework will have to incorporate risk management throughout while maintaining the governance and audit trail required for financial reporting. New processes will be built to include greater levels of disclosure for internal and external customers. Choose your solution provider wisely.
In closing, let me remind you -especially the bankers out there- that Neel Kashkari has been lobbying for systemically important banks to double their tier-1 capital buffers (from roughly 10% to 20%). Basel III be damned. Neel currently runs the Federal Reserve of Minneapolis. Before that he was the #2 guy at PIMCO, and before that he was Hank Paulson’s right hand man during the GFC. Let’s just assume Neel knows more than anyone about banking system risk and how banks should be capitalized. If Neel wants large banks to build far larger loan loss reserves, you’ll disagree with him to your peril.