As concerns continue to grow for investors due to market volatility and increasingly pessimistic economic forecasts, financial institutions should be paying particular attention. The economic news, coupled with the prospect of more interest rate hikes, not only create conditions for weakening asset quality and earnings but also highlights the importance of measuring these potential impacts on loan portfolios.
A key facet of the Current Expected Credit Loss (CECL) requirements that will be taking effect in the near term is to ensure institutions are taking into account these external forces when forecasting loan loss reserves. When the economy is stable and there is very little change occurring or expected, contextualizing the credit environment with respect to potential loan losses is less important. However, when the economy becomes volatile, or potentially so, being able to measure and gauge the impact on loan losses and earnings becomes critical.
This component of a loan loss reserve forecast (typically referred to as qualitative factors) will have to be addressed by institutions under the new CECL standard. As CECL evolves, this will need to be done so in a justifiable and quantifiable manner. For most community banks, this is not currently the case, but rather qualitative adjustments are just that – subjective with no real underpinnings.
Current Economic Conditions
When financial markets become turbulent, it tends to raise concerns about the overall economy. The stock market fell about 14% at the end of 2018. Although one may be able to find almost any economic forecast they may want, the general consensus is that economic growth will begin to slow in 2019. Most analysts are not predicting a recession this year or necessarily in the next few years, although most recognize one in 2020 is at least a possibility. The slowing of economic growth is expected to be not only in the U.S. but global.
Interest Rates
The Fed is expected to raise interest rates twice this year provided inflation remains within certain levels. Consumer confidence remains high, but business confidence has dwindled. Higher interest rates will likely contribute to lower business investment, but strength in the labor market will help bolster consumer spending.
The Impact of Economic Conditions
The economic environment does impact bank earnings and losses. How these impact particular loan portfolios and the timing is essential information that a bank will need to be able to understand, measure, and consider in estimating loan loss reserves. Such impacts will vary greatly between institutions depending on market areas, product mix, customer base, underwriting, asset concentrations, among many other possible factors.
To illustrate, in the graphic below we observe (3) measures of asset quality pre and post recession: (1) delinquencies < 90 days past due, (2) delinquencies 90 days + past due, and (3) non-accrual status. The data represent all U.S. banks and are expressed as a percent of assets. These are shown in the chart as the blue, green, and yellow lines, respectively.
We further observe (1) measure of earnings: Return on Assets or ROA. This is shown as the red line in the chart. These data are plotted over time, and the shaded area in blue represents the period of the last recession.
As shown by the graph, the recession appears to have an effect on banks generally with rising delinquencies and higher proportions of credits becoming impaired coupled with declines in earnings.
A Closer Look
Looking a little closer, there are a number of interesting and informative observations that can be noted. First, we can see that credit quality begins to diminish and earnings begin to decline before the actual “recession” begins. Just from the graph, it appears to be 1-2 quarters before the official start of the recession.
Second, we can see that earnings do not begin to recover, and the proportion of loans in non-accrual status do not reach a peak until after the recession is officially over. In fact, at halfway through the recession, loans in non-accrual are only about 1/3 of their peak level.
Finally, we see that more minor credit derogatories (loans < 90 days past due) peak prior to the end of the recession and begin leveling off before the recession is over. Major derogatories (loans 90 days + past due) follow the pattern of loans in non-accrual and do not peak until after the recession is over. However, both categories of delinquencies are less volatile and do not change as much as both earnings and loans that are actually impaired (non-accrual).
To Summarize
General conclusions can be drawn from this simple illustration. For example, banks may experience the effects of a recession months prior to the official downturn. This will be in the form of rising delinquencies, increases in loans in impaired status and chargeoffs, all of which affect earnings. Minor credit derogs appear to be less affected by recessions. The graph further suggests that a great deal of actual losses will be sustained well after the recession is officially over.
All of the above are information that institutions should be able to quantify and incorporate into not only loan loss reserve estimates and earnings but also loan pricing. (We will expound on this in future posts.) This should be specific to their institution and take into account differences by product.
It should be noted that the last recession was one of the most severe in history. We, therefore, would not expect this same degree of variation from cyclical downturns. In addition, and as pointed out earlier, such impacts can vary significantly by institution.
Viewing these data, however, should amplify the point that economic environment, both current and expected, should be valuable information in the fiscal planning as well as loan loss forecasting.
Back To CECL
So how does all this relate to CECL? With the severity of the last economic downturn and the subsequent carnage still fresh on the minds of bankers and regulators, weakening economic conditions are sure to raise concerns. For lending institutions, these concerns may manifest in the way of more regulatory scrutiny with regard to safety and soundness examinations. Although the financial crisis and certainly the timing were not predictable, the agencies clearly will want to avoid a similar situation in the future.
This will likely mean more expectations for preparedness on the part of institutions and perhaps more heavy-handed enforcement for institutions that are seen as unprepared.
CECL, in and of itself, “raises the bar” with respect to precision and quantification of an institution’s practices in regard to managing losses and capital. It is, therefore, advisable to embark on a sustainable strategy now while there is time to prepare without the additional pressure of weakening asset quality.
How to cite this blog post (APA Style):
Premier Insights. (2019, January 17). Mounting Economic Concerns Reinforce Need for CECL Preparation [Blog post]. Retrieved from https://www.premierinsights.com/blog/mounting-economic-concerns-reinforce-need-for-cecl-preparation.
