Three Ways CEOs Should Adjust their Strategic Thinking in the CECL-Era – A CECL Special Report

By Adam Mustafa, Invictus Senior Partner

Bank CFOs across the industry are sitting on pins and needles waiting for the Financial Accounting Standards Board (FASB) to announce its overhaul to the accounting treatment for loan loss provisioning. In a nutshell, this revision­—the current expected credit loss model (CECL)—will mean less earnings for banks in the future.  I will not join the cottage industry of consultants and SAAS companies by opining on why you should spend lots of money on technology to solve this problem.  Instead, this article focuses on the impact of CECL on the CEO’s world.

The risk-reward trade-off of organic growth would take yet another hit.

The heart of strategic planning is maximizing this tradeoff.  The low interest rate environment, competitive conditions, and rising asset inflation has already made the risk/reward tradeoff of making new loans far less attractive relative to historic standards.  The cost of provisioning for bad loans will only exacerbate this – especially for longer-term real estate loans, which get penalized harder under CECL since the bank will have to provision for the “life of the loan.” 

Net net – new loans will require even more capital to support them (or depending on what camp you’re in, the high cost of capital that already exists will become more transparent).  As a result, other alternatives including M&A and returning capital back to shareholders will become more attractive by default.  CEOs at the smartest banks are already looking for ways to quantify this so they can navigate the bank strategically in the way that creates the most shareholder value.   

The smartest banks will benefit because CECL will reward those banks who grow at the RIGHT time. 

One of the biggest fallacies in banking is that growth is always good.  In most industries, growth is usually always good.  Not in banking.  Growth is good in certain environments, and not in others.  In general, growth is always best at the beginning of a business cycle, not the end of one.  Consider the banks that grew rapidly in 2005-07.  Banks that grew more in 2003-04, but slowed down around 2005, fared much better because they made few loans at the peak of the real estate bubble that eventually burst.  In today’s environment, banks that grew more during 2009-11, when the economy was at the ‘bottom’ and in the early part of the recovery, actually made some very safe and resilient loans.  Those loans also have very attractive interest rates.

Banks with the right CECL tools will be rewarded since these loans need much less capital to support them.  Banks that have been aggressively growing more recently will discover that loans closed over the last year or two will require much more capital to support them because they were originated when economic conditions were at their post-crisis peak, meaning they have more downside risk.  We’re back to the old adage of “the best loans are made in the worst of times” and vice versa.   A good CECL model will capture this.

From the CEO’s perspective, CECL can provide even more clarity to help determine whether it makes sense to prioritize growth moving forward.  For those banks that grew at the right times and pulled back from growing at the wrong times, CECL will emerge as a powerful vehicle that quantifies the bank’s “story” to a CEO’s board, shareholders, creditors, and regulators.

You will need to adjust your strategy for structuring and pricing new loans.

The intended and unintended consequences of CECL will result in greater loan loss expensing for certain loans.  Since CECL would require banks to reserve for expected losses for the life of a loan, the term and structuring of a loan would take on greater import.

Take two identical CRE loans.  Imagine everything about them is the same, including that they both include 20-year amortization schedules.  However, one of the loans has a maturity date at the end of the fifth year, while the other one is fully amortizing and matures at the end of the 20th reserve. 20th year.  In that scenario, the second loan will require a greater reserve since the principal is outlaid for a longer period of time. (The ironic part is one could argue that the first loan has more refinancing risk, perhaps making it a riskier loan).  If the second loan requires a greater reserve, then it is a less capital efficient loan.  This will incentivize you to either (i) shorten the length of the loan or (ii) look to get something in return from the borrower such as a higher interest rate on longer-term loans.  This is just one example.

The bottom line is that banks will have to become even more cognizant about how they structure loans moving forward because they will have a direct impact on loan loss expenses.  This has strategic implications because competitive conditions may limit your ability to control the terms with borrowers.