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Read Our Perspective on Capital and the Allowance for Credit Losses Capital and the allowance for credit losses An opportunity exists to level the playing field among international banks We are quickly approaching the end of Implementing the Basel accords the comment period for the Notice of in a manner that creates a level US banks Proposed Rulemaking (NPR) regarding playing field is often difficult. CECL transition. While the NPR answers Achieving a level playing field many transition questions, it does not regarding capital measurement have excess, address the current unlevel playing field. levels is even more elusive given Today’s different measurement approaches the impact of disparate methods “trapped capital” for banks’ allowance for credit losses and for measuring credit losses for their corresponding impact on regulatory financial statement purposes. capital measurement rules create a that creates competitive disadvantage for US banks. Unfortunately, today’s accounting differences universally an unlevel Creating a level playing field among disadvantage US banks because international banks is a hallmark goal US accounting principles for of the Basel Committee on Banking measuring the allowance for credit competitive Supervision (Basel). As reported losses, by design, result in higher recently, Federal Reserve Governor amounts than their international landscape. Randal Quarles renewed the US’s peers. Such differences are not commitment to Basel noting the fully reflected in the regulatory benefits of a level playing field.1 capital rules. 1 “The Death of the Basel Committee has been Greatly Exaggerated”, John Heltman, American Banker, April 24, 2018 Capital and the allowance for credit losses The Basel II capital framework for Our capital rules should be designed to expected loss amount. For IRB banks, reflecting the impact of the allowance for fully and fairly address the differences the comparison of a bank’s allowance credit losses codified the concept that in measuring the allowance for credit for credit losses to a regulatory one-year the allowance for credit losses should be losses and to measure the combined ECL appropriately treats a shortage as sufficient to cover expected credit losses loss absorption capacity of the a deduction from CET1 but any excess (ECL) and capital should be sufficient to allowance for credit losses and capital is an add back to Tier 2 not CET1. This cover unexpected credit losses (UCL). consistently across the globe. Today, we asymmetrical approach ignores the extra Additionally, the Basel efforts to improve lack this consistency but correcting this loss absorption capacity in the CET1 the quality of capital after the great inconsistency is within our reach. ratio and is, in effect, “trapped capital” recession included the introduction for the important CET1 capital ratio. By of the Common Equity Tier 1 (CET1) Today, the consideration of the allowance appropriately recognizing the trapped definition. As Basel rightly acknowledged, for credit losses for regulatory capital capital imbedded in today’s capital CET1 is the primary focus of investors measurement purposes in the US uses regime, the true loss absorption capacity and regulators alike when assessing a one of two approaches. Under the US can be reported fairly. bank’s capital adequacy. Both the capital standardized approach (SA), bank-defined framework and the CET1 definition are “general reserves” are added to Tier 2 the very bedrock of today’s international capital, not CET1, subject to an arbitrary Creating symmetry capital regime, and any effort to level the numerical cap that does not consider a current unlevel playing field should be baseline ECL measurement. Under the around the loss aligned with these two principles. internal ratings based (IRB) approach, absorption capabilities the allowance treatment is asymmetrical. Beginning almost a decade ago, the That is, if the allowance for credit losses of the allowance and Financial Accounting Standards Board calculated under applicable accounting (FASB) and the International Accounting principles is less than the regulatory capital within the CET1 Standards Board (IASB) began a “one-year expected loss,” the short fall is journey to rewrite their respective deducted from CET1 capital, creating a capital ratio will level accounting principles for measuring capital floor. Alternatively, if the allowance the allowance for credit losses. During for credit losses calculated under the playing field. their independent processes, the FASB applicable accounting principles exceeds and IASB had joined forces around one the regulatory one-year expected loss, the Loan portfolio measurement categories solution only to diverge in the final lap, excess is added to Tier 2, again subject CECL IFRS 9 which resulted in the issuance of two to an arbitrary cap. For SA banks, there appreciably different approaches for is no explicit adjustment mechanism for Stage 3 measuring expected credit losses. The allowance shortages when compared to a Stage 2 differences between FASB’s current regulatory one-year expected loss. expected credit losses (CECL) and IASB’s three-stage credit model (IFRS 9) did not The current regulatory rules are neutralize the current disadvantage for asymmetrical for IRB measurement Lifetime Stage 1 US banks. Rather, their very different purposes and, as such, don’t ECL designs widened the gap between the appropriately capture the true loss allowance measurement approaches. absorption capacity of the allowance In fact, on average, 90 percent of a for credit losses if a bank’s allowance One-year ECL bank’s loan portfolio’s estimated credit for credit losses exceeds regulatory losses are measured using meaningfully one-year ECL. For SA banks, there’s no different principles—lifetime ECL under measurement mechanism to assess the CECL and one-year ECL under IFRS 9. comparison to a regulatory one-year Directionally, 90% of IFRS Banks’ loans are Stage 1 2 Capital and the allowance for credit losses To frame the current playing field, none regulatory one-year EL loss estimates 2 capital ratio could be eliminated. of the US IRB traditional commercial to the allowance for credit losses While this will not level the unlevel banks have a capital deduction from calculated under respective accounting playing field, eliminating the caps will CET1 for an allowance for credit losses principles, shortfalls would be deducted allow banks to better plan their capital shortfall as calculated under the existing from CET1 and the excesses would be management strategies to minimize the “incurred loss” model. Under CECL, this added to CET1 capital. This change to cost of the transition to CECL prior to a trapped capital increases. Conversely, the IRB approach would have the effect long-term solution. many international banks do have a of measuring capital levels similarly deduction for a shortfall even after regardless of whether an institution’s In summary, there’s an opportunity adopting IFRS 9. accounting principles approximated to take an important step to level the ECL or not. To level the playing field playing field regarding the interplay of Importantly, the impact of the under the standardized approach to the measurement of the allowance for asymmetrical treatment of the capital measurement, a standardized credit losses and capital. By eliminating allowance for credit losses in capital regulatory ECL for each risk-weighted the arbitrary distinction between measurement also must be addressed asset category could be developed. The the loss absorption capacity of the within the regulatory stress testing development of a standardized ECL is allowance for credit losses and CET1 regime. Simply stated, the impact of the not without a noteworthy effort but capital included in today’s capital asymmetrical treatment will create its certainly within reach as bank regulators framework, financial reporting by banks largest competitive disadvantage for have massive amounts of information regarding their true loss absorption US banks in the stress testing capital subject to their review and approval. A capability will be more valuable to both assessment process. standardized ECL could be developed regulators and investors. Furthermore, using information supplied by the even if the US acts unilaterally, large The Basel’s October 2016 discussion existing IRB banks’ Basel II models and international banks would not be paper, “Regulatory treatment of data, as well as information supplied disadvantaged unless and until their accounting provisions,” discussed, but as part of the Comprehensive Capital allowance for credit losses exceeds their did not solve, the disparate capital Analysis Review modeling efforts. regulatory one-year ECL. impacts of measuring the allowance Standardized ECLs should be subject for credit losses under CECL and IFRS to annual updates reflecting changing In commenting on the current NPR, 9 principles. However, the discussion economic outlooks that generally would banks have an opportunity to suggest paper did introduce a new capital correlate to CECL’s changing “reasonable alternatives, which could include the concept—a standardized regulatory and supportable” forecasts. These two-step approach discussed, that ECL—that could serve as the foundation changes would create symmetry in the would level the playing field regarding to level the playing field regarding the treatment of the allowance for loan the disparate measurement approaches interplay between measuring capital and losses for capital purposes. Adapting the for the allowance for credit losses
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