Banks in the COVID-19 turmoil: Capital relief is welcome, supervisory forbearance is not
Economic disruptions due to the COVID-19 pandemic have compelled bankers on both sides of the Atlantic to call for relaxation of accounting standards that were introduced in the wake of the global financial crisis. These standards, known as expected credit loss provisioning, were intended to limit procyclicality, namely the exacerbation of shifts in asset prices as a result of the application of accounting and/or regulatory requirements. Policymakers and accounting standard-setters should refrain from changing the applicable standards in haste and should ignore the bankers’ admonishments. There is no perfect accounting thermometer for credit risk in banks’ loan books, but breaking the current thermometer in the midst of a crisis would do more harm than good.
Expected Loss Versus Incurred Loss Provisioning
Because there are two main sets of accounting standards in the world, the debate on expected credit loss provisioning is actually two different debates echoing each other. In the United States, accounting standards are set by the US Financial Accounting Standards Board (FASB), a nonprofit body overseen by the Securities and Exchange Commission (SEC). The relevant FASB standard is Accounting Standards Update (ASU) 2016-13, Measurement of Credit Losses on Financial Instruments. ASU 2016-13 just entered into force for large listed banks, since it is to be applied on financial statements starting on or after December 15, 2019. Following a further update in November 2019 by the FASB, the corresponding date for smaller banks (all large US banks being publicly listed) is December 15, 2022.
In the rest of the world, most large banks use International Financial Reporting Standards (IFRS) set by the International Accounting Standards Board (IASB), a global standard-setting body hosted by the nonprofit IFRS Foundation. The relevant IFRS standard is IFRS 9 on Financial Instruments, issued by the IASB in November 2013 and endorsed three years later by the European Union, among other jurisdictions. IFRS 9 has been implemented for some time since it became effective for annual periods starting on or after January 1, 2018.
The FASB and IASB issued these standards on expected loss provisioning in response to prodding from public authorities through the Financial Stability Forum (now the Financial Stability Board, FSB) as early as March 2009 as the global financial crisis was raging. At that time central banks and financial ministries felt that the existing method, known as incurred loss provisioning, was leading to excessive procyclical effects when losses were indeed incurred. It is better instead, the concept went, to book a provision early on, as soon as the loss is foreseeable even if no repayment has been missed yet. There was controversy from the start on whether that might lead to a different but equally problematic pattern of procyclicality. After several years of debating it, however, the two standard-setters obliged, and research published in 2017 by the Bank for International Settlements (which hosts the FSB secretariat in Basel) concluded that the new standards had indeed been the right thing to do.
Predictably, however, banks were never enthusiastic about having to book losses earlier than under the previous methods and lobbied heavily against it on both sides of the Atlantic. Such lobbying has been predictably revived by the coronavirus shock, together with calls for more general suspension of credit loss provisioning—in other words, the recognition that loans are becoming bad, namely nonperforming loans (NPLs).
Various political and institutional figures have relayed these calls, including at the EU level the president of the European Economic and Social Committee, an advisory body. In the United States, the Federal Deposit Insurance Corporation (FDIC) has endorsed them in a March 19 letter to the FASB, with support from the Conference of State Bank Supervisors. The FDIC suggests both further delaying the implementation date of ASU 2016-13 for smaller banks and giving larger banks an “option to postpone [its] implementation.” Importantly, the other major US federal bank regulators, the Federal Reserve and Office of the Comptroller of the Currency, appear not to have echoed these calls, at least in the public sphere—which is worth noting as other recent statements on prudential policy have been made jointly by all federal regulators, as is customary.
Hasty Changes to Accounting Standards and Supervisory Forbearance Are the Wrong Responses
Such calls should not be heeded. As of mid-March in both the euro area and the United States, banks have been granted very significant capital relief—namely, they can let losses eat into their capital buffers as these have been built up significantly over the last decade in application of the global prudential accord known as Basel III. This welcome action implies that banks have a considerable capacity to absorb losses in the near future, without breaching their regulatory and supervisory capital requirements. No miracles will (or, in fact, should) happen in terms of credit expansion, given the parlous economy, but credit will not unduly contract as an effect of procyclical regulatory constraints, and financial stability is protected. These decisions were made swiftly—not least in the euro area, where European Central Bank (ECB) Banking Supervision was able to act at a pace that would have been impossible in the pre–banking union era, given challenges of coordination and stigma effects. Banking union remains of course unfinished and has not achieved its stated aim of breaking the bank-sovereign vicious circle, but this episode demonstrates its tangible benefits.
Because the capital relief allows banks to absorb losses, changing the loan loss provisioning method now is unnecessary. It is also undesirable, because there is significant value in reassuring investors and the broader public that banks are not allowed to hide bad news and move stealthily towards “zombie” status. At a more basic political level, this is not the time to give banks special favors if these can be avoided. Longstanding experience suggests that supervisory forbearance—namely, allowing banks to pretend they meet regulatory requirements when from an economic standpoint they don’t—should be considered only as a last resort. It is not justified under the present circumstances. (Loan forbearance by the banks themselves, namely letting borrowers miss scheduled payments without triggering collateral execution, is a separate matter.)
In the euro area, there is an additional dimension given the ongoing discussion about cross-border risk-sharing and solidarity. While political difficulties abound, there is willingness to share some of the burden of fighting the pandemic and preventing economic collapse—but that cannot be expected to extend to bank rescues. Italy is at the center of current concerns, because of both its high sovereign indebtedness and its tragic exposure to the pandemic. The Italian Banking Association has lobbied for supervisory forbearance. Italy’s true priorities do not lie there.
In the euro area, the ECB has complemented its March 12 capital relief decision with additional guidance on March 20, allowing banks to provision as few losses as possible within the constraints of IFRS 9 and providing favorable interpretations on related matters, e.g., not classifying loans in arrears as NPLs if they are covered by a government guarantee. Simultaneously, the ECB has made it explicit that it rejects “forbearance for NPLs” and that “[i]t remains crucial, in times of distress, to continue identifying and reporting asset quality deterioration and the build-up of NPLs in accordance with the existing rules, so as to maintain a clear and accurate picture of risks in the banking sector.” In the United Kingdom, the Bank of England has taken a similar stance.
In the United States, the FASB should resist the FDIC’s pressure to exempt large banks from implementation of ASU 2016-13. Smaller banks are a less critical concern, with potential space for compromise on implementation schedules.
The Basel III Experience
The last few days have spectacularly illustrated the ancient wisdom that bank lobbying on capital and accounting should generally be resisted in the public interest. Banks had lobbied tooth and nail against Basel III, its multiple buffers, and related constraints on capital, leverage, and liquidity. But having these buffers in place is precisely why authorities have been able to provide a credible response (so far) to concerns about banking sector stability in the pandemic crisis.
Authorities should implement Basel III’s remaining items in due course and steadfastly resist appeals for supervisory forbearance. The banking system is critical to society and requires due attention and support. But in doing so, tough love is preferable to complacency.