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There has been much focus (and rightly so) on modeling of the loan loss reserve under the new CECL standard. Less attention has been paid to the impact from CECL on a bank’s capital and earnings. Many banks are in the process of preparing their 3-year strategic plans at this time and they would be wise to incorporate CECL into their planning. Banks that are SEC filers have a shorter window to comply with the CECL standard so there should be a greater sense of urgency on their part. However, the ‘knock on’ effects from CECL will be pervasive and all banks need to plan on existing under this new paradigm.
Let’s discuss the impacts from CECL and their implications to a bank. As it relates to capital, banks will have to take an adjustment to retained earnings as of the beginning of the first reporting period in which the CECL guidance is effective. The adjustment will reduce shareholder’s equity and pressure capital ratios. The composition of the balance sheet will dictate the size of the CECL reserve and the accompanying adjustment. The Basel committee has proposed a longer transition period for the adjustment to be fully phased in and banks have also petitioned regulators for additional relief as it relates to lifting the cap on the amount of the ALLL reserve that could be included in Tier 2 capital. These proposals are still pending though and banks need to prepare accordingly.
The provision for loan losses will also be based on expected losses over the life-of-loan and therefore, on a recurring basis, could be larger than it would have been under current GAAP. The ‘delta’ depends on many variables including, most importantly, the composition of the loan portfolio. However, a larger provision translates to lower net income, all else being equal.
Putting it all together, CECL is likely to reduce a bank’s return on capital. Bank stocks do not appear to have factored any of this in. We believe that investors will begin paying attention to CECL once the current activity around tax and regulatory reform subsides. There are steps a bank can take to mitigate these impacts from CECL and senior management at banks should start planning now.
At Oakleaf, we stand ready to help you navigate these goals. Please contact me if you have any questions.