June 22, 2016

Hardheaded bank regulators still believe they’re up against the expected while the real enemy is always the unexpected

Sir, Ben McLannahan discusses the consequences of changing “the current regime [in which] banks can hold off adding to reserves until the point at which losses on the loan become probable…[to one in which] banks will be made to log all expected losses over the life of the loan on day one, based on a combination of experience, their own forecasts and the state of the economy”, “Big lenders raise concerns over new loan loss rules” June 22.

One direct consequence of that is that those borrowers who are ex ante perceived as risky, will therefore force banks to recognize losses earlier than “when probable”. That might sound correct, but the real effect is that, when compared to those ex ante perceived as safe and which have lower probability of losses, it will discriminate against the risky.

And so when you layer this on top of the discriminations already produced by the risk weighted capital requirements for banks, the access to bank credit for those perceived as risky will only become more difficult. And all really without making banks much safer. The expected never causes major bank crises, it is always the unexpected losses for what had erroneously been perceived as safe that does.

McLannahan reports that Hal Schroeder, a board member at FASB, opines that the new rule — known as the Current Expected Credit Loss, or CECL — “aligns the accounting with the economics of underwriting, and the informational needs of investors”.

And to justify it Schroeder “noted that in the four years before the crisis, loans held by banks in the US rose 45 per cent, while reserves set aside for losses fell 10 per cent. That meant that loan-loss reserves as a percentage of gross loans were near a multi-decade low on the eve of the Lehman collapse.”

But why was that? That was the result of banks increasing their exposures to what was perceived as safe, because of lower capital requirements, and lowering their exposures to what was perceived as risky, because of lower capital requirements… and then being surprised when “super-safe” AAA-rated securities, backed with “super-safe” residential housing mortgages, and loans to sovereigns decreed as “super-safe”, like Greece, turn out, ex post, un-expectedly, against probabilities, to be very risky.

Sir, what’s being done here, especially without eliminating the risk-weighted capital requirements, evidences that the regulators still don’t understand that they are not up against the expected, their real challenge is the unexpected. Since what is perceived as safe has much more potential of providing unpleasant surprises than what is perceived as risky, their regulations just makes the bank system more brittle and fragile.

And to top it up by discriminating against the risky they hinder the banking system from taking the risks the real economy needs to move forward.

We need our banks to work for all, not just for the banks, and for those perceived as safe.

We need our banks to finance the riskier future of our young, not just refinancing the safer past of their parents.

@PerKurowski ©