WRITTEN BY DEREK HIPP, CPA & DIRECTOR OF CONSULTING
Valuant has updated the technical series whitepaper, CECL: First Year in Review, detailing the impacts and trends related to the allowance for credit losses for the banks that adopted CECL on 1/1/2020. The study now includes a full annual cycle with analysis covering pre-adoption date through 12/31/2020. For comparison purposes, we held the dataset consistent with those institutions included in the prior study. As a reminder, this includes regulated financial institutions traded on a Major Public Exchange (NYSE, NASDAQ, OTC), with total assets as of 12/31/2019 of less than $400 Billion.
As we moved past the fourth quarter and the final reporting period for the selected banks, most took a deep sigh of relief. 2020 was challenging for everyone but for the banking industry, the universe lined up events perfectly with a Global Pandemic striking at the same time a new and complex accounting standard went into effect. I am sure members of the Financial Accounting Standards Board were thinking to themselves, “Can you believe this timing?” Murphy’s Law, I guess.
Themes held consistent during the final reporting period with those shown at 9/30/2020. Some clarity came as the Presidential Election was decided and COVID-19 Vaccine distribution plans began. Also, an additional stimulus bill was passed on December 21, 2020. Among other things, The Consolidated Appropriates Act provided another round of the Paycheck Protection Program loan program, State and Local Government Federal Aid, direct payments, and expanded unemployment benefits. However, against the backdrop of positive news and additional stimulus, the COVID 19 Vaccine distribution plan began slower than anticipated and job growth began to slow. While significant improvements in the National Unemployment Rate were shown from April 2020 to October 2020, November and December statistics showed the Unemployment Rate holding constant at 6.7%. Furthermore, many states still had
protocols in place limiting indoor dining, public gatherings, and other functions that continued to impact the most at-risk industries related to COVID 19 including hospitality, restaurants, and entertainment.
Against this backdrop, overall reserve ratios held constant at 12/31/2020 to that shown at 9/30/2020 of 1.49% of Total Loans (including loans held for investment and loans held for sale). However, it is important to consider that a significant portion of Paycheck Protection Program (PPP) Loans were forgiven and/or paid off during the 4th quarter. Most institutions held little to no reserve against these loans and therefore the comparison to prior periods can be misleading. Excluding PPP loans, this would demonstrate that most institutions held reserve levels constant or had negative provision for credit losses in Q4 2020. Excluding PPP, most institutions held reserve levels constant or had negative provision for credit losses in Q4 2020.
This concept was also true in the periods of Q2 and Q3 2020 where many PPP loans were added thus reflecting a lower overall coverage ratio than would be shown excluding these loans. Most institutions have provided transparency on reserve levels including and excluding PPP loans in their SEC Filings. However, those statistics are outside the scope of this update and will be addressed in a more technical revision to the CECL: First Year in Review Whitepaper. A graph below details reserve levels by both asset size grouping and Census Bureau Region.
As one studies the trend analysis shown, it is important to compare these reserve levels to the overall economic environment. By doing so, one can gain a clearer understanding of both management’s expectations as well as the overall composition of the Allowance between quantitative and qualitative measures. The graph below charts the average coverage ratio to the ending National Unemployment Rate at each reporting period.
As everyone reading is aware, forecasting is a significant component of the CECL calculation. During the first and second quarters of 2020, economic outlook was bleak and the quantitative components of most institutions’ reserves were significantly higher than that shown in Q3 and Q4. While the graph above displays Unemployment at a point in time/period end date, it is clear that while Unemployment was rising, reserve rates were growing substantially. However, while Unemployment was falling, reserve levels have held constant.
The mechanics of CECL are certainly in play here with a forward looking concept, but it can be noted that in the back half of 2020, the composition of reserve levels held much more quantitative amounts than in the first half of 2020. Operationally, this can be accomplished in several ways but we most often see this through multiple economic scenarios considered. For banks where this is done in the quantitative reserving process, qualitative factors may be lower than those where multiple scenario analysis/forecasting is shown in the qualitative process only.
As we move into 2021 reporting periods, more institutions will come online with CECL reporting either by early adoption or fiscal periods ending after 12/31/2019. For these institutions, challenges continue to exist, but they will have insights that the earliest adopters did not have. Discussions in Congress point to more stimulus packages on the horizon. Will this lead to more institutions planning to adopt early? Will the losses that have been reserved for over 2020 be taken in 2021? As is the continued theme, many questions and uncertainty remain. Through Q3 and Q4, banks have shown reluctance in releasing reserves built earlier in the year. However, as the environment continues to improve, it is expected that a large reserve release is on the horizon. While not shown in Q4, there were many institutions that began this trend, and we would expect that to continue in the coming reporting periods.