U.S banks will henceforth begin booking provisions for potential loan losses this year. The early warning system for bad loans is intended to mitigate losses to prevent the huge financial losses most of the banks suffered during the last financial crises.
The new system was proposed in 2012 but was not implemented until this year. Most banks are in support of the new system as it would help them avoid the damaging surprise that caught the regulators and the industry off guard during the past financial crisis.
The reason behind this recent development is to enable banks to boost their reserves according to economic indices, rather than depend on loan payments to stop.
The system not set on the solid rock yet
Although some analysts have commended this development, some critics are still raising concerns about the effectiveness of the system due to the heavy swings in estimated loan losses. According to the experts, the system has the potential to send mixed signals or raise concerns prematurely.
When the rule, known as CECL, was proposed in 2012, analysts and regulators estimated that the four largest banks in the U.S. would have a provision increase of $56 billion. However, banks said last week that the estimate is false and it’s just $10 billion.
That makes it a $46 billion gap at Citigroup Inc, Bank of America Corp, and JP Morgan Chase & Co. It shows the lenders’ assumption and economic shift can have a big impact on estimates.
This is a level of secrecy that will allow executives to set off a surge in provisions or delay higher reserves if they are conventional in the next economic slump.
According to an accounting analyst, Maria Mazilu, the new rule could usher in higher volatility. However, she pointed out that the banking industry will only know how effective the new rule would be during the next financial crisis. That’s only when the effectiveness of the new rule could be seriously tested, she reiterated.
Banks criticisms prompted the new rule
The rule came to light as a result of the heavy criticisms on the global banks for their slow response to potential loan losses as the 2008 crisis began. The rule will inform shareholders in time in case there is any looming danger by basically amplifying expected loan losses in accordance with the level of the economic cycle.
When the rule was initially proposed, the United States was heading out of one of the worst recession crises and estimates were not high. However, since the crisis, banks have revamped their lending procedures.
Some are currently anticipating a financial crisis after the economy has seen a progressive economic growth for the past few years. That is why many banks are looking to improve their reserves to stand firm when the financial crisis eventually hits the finance sector.
David Solomon, CEO of Goldman Sachs Groups, said that at some point there would be booms and busts, however, it’s unlikely that any boom is coming soon. How the new rule responds to the looming financial downturn will only be known when the banking sector approaches the crises.