Large and Small Banks Must Have a Holistic Approach to Maintain Solvency

CECL  »  Large and Small Banks Must Have a Holistic Approach to Maintain Solvency

The U.S. Economy rose 2.6% in the fourth quarter according to the BEA’s third and final estimate released March 30th. This latest estimate marked a slight downward revision from the previous fourth quarter estimate of 2.7% and a deceleration from the third quarter growth of 3.2% growth. Despite the two quarters of back-to-back above trend gains, most economists anticipate growth for 2023 to be subpar. The March 10th Blue Chip Consensus forecast anticipated a 1.0% growth for the year. That is not expected to change substantially in the April release.

The relatively pessimistic outlook is due in part to tighter financial conditions which are expected to stress interest rate-sensitive sectors of the economy. To say the least, the recent failures of Silicon Valley Bank, Silvergate Bank, and Signature Bank have raised concerns in the banking sector.

“Too Big to Fail” and the Flight of Deposits 

Some have argued the failures of these institutions were unusual and not a harbinger of widespread weakness, citing Silicon Valley Bank’s close ties to the technology sector which has suffered over the past year, and both Silvergate Bank and Signature Bank’s vulnerability to the declining crypto markets. All three banks had an unusual number of depositors with deposits in excess of the FDIC insurance limits, making the banks vulnerable to a run once panic set in. However, given the combination of risks financial institutions are facing, including a recession and rising interest rates, a posture of hyper-vigilance is warranted.

For regional and smaller banks, the “too-big-to-fail” response may have made things even tougher. The Wall Street Journal reports that bank’s social media accounts noted discussions of customers moving their money into larger banks. Citing Federal Reserve data, they reported that the 25 largest U.S. banks saw a gain of $120 billion in deposits in the wake of the SVB failure. Banks below that level saw a $108 billion loss of deposits over the same period.

CECL, and Why It Isn’t Enough

For the viability of both the banks and local communities, small and regional banks must adapt to the new environment. Specifically, that means comprehensive risk management which goes beyond loan portfolio risk management to include institutional risk management.

The Current Expected Credit Losses (CECL) accounting standard has garnered much attention over the past several years. Fostered in part by scandals related to misleading financial reporting as well as the financial crisis of 2008, the new standard was intended to help financial institutions more fully measure and quantify credit risk. It received a lot of attention because the implementation was delayed for a long period of time, but also because it is unique (and sometimes confusing) conceptually.

Although it is an accounting standard, understanding and applying the concept of CECL is an intersection of complex and highly specialized disciplines, including accounting, economics, statistics, and forecasting. All institutions were required to implement CECL as of the end of 2022. 

We believe CECL is still evolving and that there remains a great deal of confusion and misunderstanding surrounding it. Much of this will not be ferreted out until there has been some history of regulatory scrutiny related to safety and soundness under CECL.

Although CECL represents an improvement in how institutions estimate credit losses in moving from an incurred loss to an expected loss approach, management of credit quality is inadequate by itself for an institution’s financial soundness. There can be other hidden stresses that become evident for an institution in periods of economic duress beyond asset quality, although declining asset quality could be a complicating factor. Focusing on and managing credit quality alone, although critical, is insufficient for viability.

Banks mitigate credit risk by estimating potential losses through the allowance for credit loss (ACL) analysis. Banks use the current expected credit loss (CECL) to estimate expected credit losses over the life of financial assets. But that approach does not ensure the financial institution has the capital to sustain a prolonged downturn in which collateral markets remain negative and income is reduced for an extended time. 

Banks’ margins too, have been squeezed over the last several years due to historically low interest rates, which is now coupled with a rapidly rising rate environment. While too-big-to-fail banks can expect the Fed to lend against their fundamentally good collateral, the smaller banks have no such guarantee. 

A comprehensive or holistic approach to risk management would include not only the portfolio analysis, but Asset and Liability Management (ALM) to mitigate liquidity and interest rate risk. While larger banks are generally more adept at this, smaller and regional banks need to be doing this as well.

Bill Felder, Managing Director and President of Harper, Rains, Knight and Company, an accounting firm, explained that while current rules of accounting do not require stress testing of the financial institution in determining accumulated credit losses, there is certainly leeway within the regulations to do so. Furthermore, he explained that “regulators, such as the Federal Reserve Board and the Office of the Comptroller of Currency have issued guidance to incorporate stress testing into financial institutions risk management programs.”

Banks will want to be cautious in distinguishing between what is expected and what could potentially occur with regard to the ACL. The use of worst-case scenarios is common in stress testing but would not be appropriate under the CECL as it does not represent the institution’s actual expectations of future conditions. Clear support and documentation throughout the analysis will be essential in balancing the expected risk to the portfolio and the potential risk of a long-term or severe downturn.

However, apart from the ACL, institutions must be aware of the impact other stressors may have on short and long-term viability in addition to monitoring credit quality. Banks should also understand the impact of additional regulatory scrutiny in regard to safety and soundness, in which in and of itself can be an added stress.  A program that is perceived as weak or deficient may bring additional pressure on an institution. There was no shortage of “regulatory-induced” failures of banks with weak management during the financial crisis of 2008. Banks need an approach that is comprehensive and aggressive enough to inspire confidence.

Institutions should consider these risks and pursue mitigating measures. Felder stated, “I would hope banks have already ramped up their stress testing and asset/liability analysis to weather the upcoming economic issues and adjusted accordingly.”

There unquestionably will be more uncertainty and financial pressures to come. While proper estimation and anticipation of expected loan losses is critical, this is only one side of the equation with respect to managing safety and soundness risk. 

Given the current environment, it would be prudent (although not required) for smaller banks to consider adding stress testing or more formal controls to their ALM.

We will continue to monitor these and other issues. Please feel free to reach out to us anytime to discuss any challenges you and your institution may be facing.

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