Jeff Judy

Jeff's Thoughts - June 19, 2013

Change the Language, Change the Industry

Banking and credit are all about the future. We extend credit based on (a hopefully well-reasoned) belief that the borrower will be successful enough in the near future to repay the loan. We know all about running projections on individual borrowers, and about forecasting the future state of our credit portfolios.

Those forecasts lead to defensive maneuvers, if you will, in the form of managing loan loss reserves and capital. They are the key to finding the "sweet spot," as we call it, between reserving too little to protect the bank, and reserving too much, thus sequestering resources that could be used to grow the bank.

All this is well and good, but before we get sore shoulders from patting ourselves on the back for being so foresightful, let's admit that a lot of times, portfolio forecasts are not much more than educated guesses. (In fact, as the economic downturn revealed, in many cases they were fairly uneducated guesses, but that's a different discussion.) For instance, it is pretty common for institutions to look at their previous ALLL and tweak it up or down. That tweaking approach, first, tends to produce a lag: either protection is increased too slowly in the face of problems, or resources are set aside too aggressively when conditions are good. Second, tweaking can miss major shifts in the quality of the portfolio entirely.

With this in mind, the recently proposed Accounting Standards Update from FASB caught my attention. Announced in December of 2012, FASB says this proposal offers "a new accounting model intended to require more timely recognition of credit losses, while also providing additional transparency about credit risk." (The new model would apply to all FDIC-supervised institutions.)

At the heart of the proposal is a drive to truly look ahead, to take the art and science of predicting the future of the credit portfolio more seriously. They state, "The FASB's proposed model would utilize a single "expected credit loss" measurement objective for the recognition of credit losses, replacing the multiple existing impairment models in U.S. GAAP, which generally require that a loss be "incurred" before it is recognized."

The commenting period concluded at the end of May, so it is likely that the final standards will appear later this year. And it is just as likely that that will be none too soon for most banks to start thinking about how they are going to adapt to the new standards.

Those adaptations are likely to force many banks beyond the "tweak the past" model of reserving. Truly forward-looking portfolio analysis will be needed to meet these standards. New analysis tools, new data collection practices, new standards for conversations about credit quality with your staff may all be necessary.

We're basically talking about a shift of the industry culture, from "What just happened?" (incurred losses) to "What will happen?" (expected losses), where these forecasts are based on hard data and hard thinking, not tweaks. A cultural shift of that magnitude, combined with the processes and technical tools to generate meaningful portfolio forecasts, hardly happens overnight.

I'll have more to say about adapting to the new FASB standards in later issues of Jeff's Thoughts, as more details emerge.

In the meantime, it is not a bit too early for you to put on your thinking cap and reflect on what will need to change in your bank to accommodate this change of accounting expectations.