A decade has passed since the massive 2008-2009 financial crisis. Next year, an important new accounting standard is slated to go into effect. It is supposed to address prior weaknesses that were asserted to lie in the intersection of bank capital regulation and accounting principles.
This relates to how banks and other financial firms like insurance companies recognize losses in their financial assets. The world is moving from a prior “expected loss” framework, where entities didn’t recognize losses until they were deemed “probable,” to a new “current expected credit loss” (CECL) framework.
The expected loss framework has been blamed for keeping entities from using forward-looking economic forecasts, expected credit deterioration among borrowers, or consideration of industry cycles in determining whether a “probable” loss had already occurred. The accounting and financial regulatory powers-that-be criticized the old model for allowing entities to not fully reserve for losses expected to develop in the future.
In hindsight, of course, the 2008-2009 disaster certainly happened – however well large financial institutions and their government overseers/enablers saw it coming or not.
The new CECL accounting analysis now requires entities to estimate and recognize future credit losses at the moment of recognizing the asset, and on an ongoing basis for future reporting periods. The considerations for making these valuation calls will include superficially more-sophisticated forward-looking appraisals, including “reasonable and supportable forecasts” for the lifetime of the financial instruments.
Have we taken a step in the right direction? Have we reduced taxpayer exposure to government bailouts of the financial sector in the future?
A few months ago, University of Chicago Booth School accounting professor Haresh Sapra penned an insightful (and readable) review of the new lay of the land. Titled “Why the big banks aren’t safe yet,” Sapra outlined uncertainties in bank capital regulation, given how accountants and bank regulators aren’t always singing the same tune.
For example, bank regulators may stipulate that banks hold a certain amount of capital compared to assets. But how “certain” that capital is depends on the uncertain accounting value of assets; if banks are not recognizing loan losses promptly that could make capital regulation more lenient than believed (or advertised) by bank regulators.
I’m reminded of a joke that was making rounds on trading desks back in the financial crisis. “Nothing on the left is right, so nothing on the right is left.”
In his August 2019 article, Sapra chose to try to be optimistic about the new CECL framework, noting that it could allow lenders to more proactively recognize losses in their asset valuations. But he was careful to caution about the “silos” in which accounting and financial regulation operate.
This has created silos in which accounting is often left out in the cold on discussions of the overall stability of the financial system. My research demonstrates that banking regulators should take accounting seriously, and accounting standards setters should take banking regulation seriously.
I agree, and would add another note of caution. The new, more sophisticated-looking asset valuation framework can also provide more room for discretion in not recognizing losses. And I’m reminded of the “new,” more sophisticated and “risk-sensitive” bank capital regulatory framework arising out of the Basel Accord beginning back in 1988. That framework turned out to be gamed as a means for effectively reducing capital buffers in the banking system. It arguably raised, not lowered, the risks leading up to the 2008-2009 crisis.
Bank regulators and the accounting community should heed Sapra’s call for taking each other seriously. Hopefully, they won’t do so in a way that exposes us to disaster again. And we can’t just rely on their claims to good intentions.
We the People need to Watch our Wallets.