Haresh Sapra: Now Is Not the Time to Relax Accounting Standards

I don’t think that is a good thing, because this standard has been debated at length, and banks had already started implementing it. This is precisely the time when banks need to be monitoring the risks of borrowers. The idea is that the government is sending all of its money to borrowers, to companies, to try to invest, and banks need to be figuring out to whom to lend money. Are they lending it to companies that really need it because they’re struggling now, or are they lending it to companies that would have struggled regardless of the coronavirus? This is precisely what the expected-loss models do, help banks answer these questions.

How do expected-loss models help banks improve lending?

The idea is that [banks] are monitoring risk carefully, and they’re using this risk model to write down loans, so they’re being proactive about identifying risky borrowers. There’s a lot of uncertainty in the economy, and board members, executives, and managers need to get this information so that they can make sound and efficient decisions. Delaying implementation of the standard is not a good idea.

Interestingly, the Federal Reserve is saying that if companies or banks continue to use the CECL, they’ll give them capital relief. That’s a good idea. Why? Because if you, as a bank, monitor your risk carefully, you can also benefit from relaxed capital requirements, and that would spur lending. This is the best of both worlds. You are monitoring the risk, getting good information about the risks you’re making to borrowers, and at the same time you’re relaxing the capital requirements. That’s a move in a good direction.

Keep in mind that banks have a choice here. Either they delay the CECL and don’t get the capital relief, or they continue using the CECL and get capital relief. The latter, in my mind, is the better option. In fact, this is consistent with something that I’m finding in my research. My coresearchers and I demonstrate, using an economic model, that banking regulators and accounting-standard setters need to harmonize their regulation. In other words, if you require banks to use the CECL, at the same time, you need to see how your capital requirements should adjust in light of banks being more proactive in monitoring their risk.

In contrast, banks would be misguided if they did not use the CECL appropriately, if they essentially ignored the accounting standards and chose the delay, implementing the standards at the beginning of 2021. It’s misguided because it would hurt the real economy. Banks need to be lending—that’s the point of the CARES Act. The government is giving money to banks to lend to borrowers. If we stop lending right now, it would hurt the economy for a long period of time.

But in fact, without the CECL, banks could be lending to the wrong types of borrowers, and then there would be huge write-offs in the future. This would take us back to the 2008–09 financial crisis, when banks were lending money to borrowers who were essentially poor risks. It took a while for us to recover, and we should not make that mistake again.

During the financial crisis, the banks were the bad guys. This is no longer the case. There have been a lot of changes in regulation, such as stress tests—implemented by the 2010 Dodd-Frank [Wall Street Reform and Consumer Protection] Act—and increased capital buffers. Banks are not the bad guys here, but they have an opportunity to be the good guys, because in being careful in helping to channel this money to the right companies, they could help spur the real economy. I view this as a great opportunity, but it would come from banks implementing the CECL appropriately.

What are the biggest challenges companies are facing?

The biggest challenge they are facing is a cash crunch, because essentially everything in the economy has been frozen. Companies are losing their customers. They have to continue paying their suppliers to make sure that they maintain these relationships. So most companies are facing a cash crunch, but it’s temporary, and this is precisely the objective of the CARES Act. The government needs to funnel this money to companies so that they can keep paying their suppliers and their employees while they’re not collecting cash from customers. The customers will come back, but this is going to take time. Most people are at home, and they’re focusing on the most basic needs: toilet paper, masks, and food. Some businesses are benefiting from this, but the general economy is really hurting.

Getting cash from the government, paying employees, and gradually coming back out of this is going to take time and patience. But the important thing is that banks need to keep lending so that companies can keep making their payments. This is where, again, accounting would help, because those companies that are disciplined in their risk-taking, and banks that are properly monitoring these risks, will emerge from this crisis in much better shape.

These are probably the most uncertain times we have faced in the world economy since the Great Depression. Interestingly, though, now we have better accounting systems in place to try to monitor or manage this uncertainty.

There’s a silver lining in this coronavirus episode. Revenues have shrunk, but companies want to maintain relationships with their employees. This provides an opportunity. Most companies are generating losses, therefore this is the time when they could look at activities such as research and development that they had cut back when they were worried about generating profits. Why not look at the important decisions that they’ve been postponing and start getting employees to think about them? Most of their employees are working from home, away from the distractions of the office. Why not use this opportunity to look at decisions that have been postponed that require large investments? Shareholders are going to be willing to tolerate this type of risk at this moment.

In terms of the accounting, all of this would be recognized as an R&D expense, and so their share prices won’t be hurt as much. I think companies realize it, and going down that path is going to help them. They’ll emerge from the crisis perhaps in much better shape than they think they are in right now.

In the policy debate, the CARES Act is going to be helpful. I also believe that banking regulators providing capital relief to banks is a move in the right direction. What is important to keep in mind is that we need to be patient in terms of how we deal with this crisis, in the sense that executives and managers need to be given time to resolve these issues. If the regulators come out with a unifying message that this is a short-term crisis that will go away, we’ll emerge stronger, and the economy will do better in the future.

It’s interesting to me that every time there’s a major crisis, people talk about accounting. Think of the 2008–09 financial crisis: what came to the forefront was something called fair-value accounting. Banks were marking to market their loan portfolios, and there was a lot of criticism that accounting was causing the crisis. I don’t believe it was. At best, fair-value accounting was revealing the type of risks that banks were taking, and maybe that, perhaps, provided a catalyst for banks to write down their loans.

The same thing is playing out again. There’s a feeling that the way you do your accounting could be making things worse during the crisis. In a crisis, it is important that you build trust. Fair-value accounting allowed banks to be transparent during the financial crisis, and the expected-loss model also allows banks to be transparent during a financial crisis. That’s a message not just for accounting, but for politicians. It’s important to be transparent during a crisis—that way you build trust in the economy and among people. This is precisely the time when people want politicians, not just banks, to be trustworthy. It’s not just accounting; it’s part of everyday life. Being trustworthy is probably the best medicine right now.