(Bloomberg) A new accounting rule that will force banks to set aside provisions for bad loans long before they sour could cannibalize profits and eat into capital at U.S. lenders.

It all depends on how the economy is doing when the standard goes into effect in 2020. The rule, approved by the Financial Accounting Standards Board last week, would have a negligible impact on profits or capital at U.S. banks under current credit conditions. If the economy is in a recession or coming out of one, the amount banks need to set aside could surge.

For the four largest U.S. lenders, the difference could be eightfold, based on a comparison of 2015 estimates of the rule’s impact and those based on data from 2011, when loans were going bad at a higher rate. At JPMorgan Chase & Co., the biggest U.S. bank, that difference could amount to $12 billion and at Bank of America Corp. almost $16 billion. Spokesmen for all four banks declined to comment.

“It’s very hard to guess where the economic cycle will be by the time the rule comes into effect,” said Christopher Wolfe, a bank analyst at Fitch Ratings. “If the rule were adopted today, in the current economic environment, the hit to capital would be easily manageable. But it could be significantly different in a few years. We just don’t know.”

Future Performance
The new standard, which requires banks to provision for losses on all loans when they’re made, based on expectations about future performance, came about in response to criticism during the 2008 financial crisis that lenders were slow to record losses on souring debt. It aims to speed up that process and keep a certain level of reserves so losses don’t jump in times of stress. That means there will be a one-time increase in provisions when the rule goes into effect—and that increase could vary by billions of dollars depending on where in the credit cycle the nation’s economy is.

Any increase in reserves reduces a bank’s net income, and that means a slower accumulation of capital through retained earnings. If there’s a loss as a result of higher credit costs, capital is reduced by that amount.

The final version of the rule will be published in June after FASB staff rewrites the latest draft incorporating the board’s decisions over the years. Last week the board voted to give banks an additional year and smaller lenders even more time to comply. Community banks also won incremental disclosure requirements on legacy loans.

The efforts to change how banks account for potential bad loans go back to 2010. FASB’s first proposal called for marking all loans to market values, which would have been even harsher in forcing recognition of deteriorating economic conditions.

Push Back
Banks pushed back, arguing that the typical industry model isn’t based on selling loans but on holding them until maturity and writing off the bad apples along the way. FASB came up with a revised version in 2012, which focused on faster recognition of bad loans. That concept remains intact in the latest draft FASB distributed at an April 1 meeting with banks and auditing firms.

When FASB released its 2012 version, then-chairman Leslie Seidman said the biggest U.S. banks were estimating their reserves could jump by about 50 percent. A subsequent study by the Office of the Comptroller of the Currency using 2011 data provided by lenders predicted the increase would range from 30 percent to 50 percent for U.S. banks, according to people briefed at the time. The OCC never made the study public.

In 2011, when the economy was still recovering from the 2008 crisis, nonperforming loans made up about 3 percent of lending at U.S. banks with assets greater than $500 million. Last year the figure was about 1 percent. The makeup of loan portfolios has also changed. Some banks have reduced mortgage lending, while others have expanded into home loans. That could affect the rule’s initial impact in a future stressed environment.

Based on today’s more benign credit environment, investment bank Keefe, Bruyette & Woods estimates reserves at the four largest U.S. banks would increase by 13 percent on average if the rule were to go into effect this year. In a recession, the OCC’s estimate of a 30 percent to 50 percent jump would be more relevant, according to Brian Kleinhanzl, a KBW analyst.

“Who knows how bad the next recession will be?” Kleinhanzl said. “We could have those rates back again or even worse next time.”

Convergence Effort
If such a recession coincides with the adoption of the accounting standard, reserves could already be elevated as loans go bad faster. That would require banks to increase their expectations for future losses, leading to a much bigger one-time charge on earnings. Banks can adopt the rule earlier than required but not before 2019.

Initially, FASB and the International Accounting Standards Board, which sets accounting rules for most of the rest of the world, aimed to revise loan-impairment standards together as part of an effort to converge U.S. and international accounting regimes. They ended up going in different directions, as they have on other issues.

The international standard, which was approved in 2014 and goes into effect in 2018, asks banks to consider potential losses only for the next 12 months at the time a loan is made. If they see further deterioration in credit quality, they’re required to estimate losses over the lifetime of the loan. That means upfront provisions would be much smaller than the U.S. standard given the same economic conditions, analysts estimate.

But economic conditions aren’t the same. In the euro area, still recovering from a 2012-13 recession, nonperforming loan ratios are higher than in the U.S. European banks would need to set aside more reserves initially to comply with their new rule if it were adopted now. KBW’s European analysts estimate the initial hit to capital to be 0.47 percentage points on average under current conditions. That compares with 0.17 percentage points for U.S. banks if the FASB rule went into effect today. Europe could be in a different part of the credit cycle by 2018.

Compliance Costs
Banks have complained that the new rules will increase costs as calculating loan-loss reserves becomes more cumbersome. Especially in the U.S., where lifetime losses are required to be estimated on day one, industry opposition has been loud.

FASB clarified in its latest draft that it wouldn’t require smaller firms to build new complicated models to forecast loan losses but would let them use existing methods. Banks will still struggle to estimate losses and may end up spending a lot on new systems, said Michael Gullette, vice president of accounting at the American Bankers Association, an industry group.

“Looking at the examples included in the draft rule, you might think it’s very simple to just add on a few basis points of losses when the economy isn’t doing so well, but it’s not that simple,” Gullette said. “You need to show auditors some math on how you got to those specific basis points.”

Others say the new rules will hinder credit growth as banks are required to record losses on loans from the outset. Even for European banks, the upfront cost of a loan will be difficult for undercapitalized banks to shoulder, according to Hari Sivakumaran, a London-based KBW analyst. Under stable economic conditions, each 1 percent of growth in lending would have a negative impact of 0.1 percent on earnings and capital, he estimates.

Cookie Jar
Almost everyone agrees the rules will increase subjectivity. Guessing future losses, even by using past experience as a yardstick or sophisticated models, is an inexact science.

A rise in subjectivity would mark a swinging back of the pendulum. In the 1990s, regulators warned banks not to use loan-loss reserves as a cookie jar to smooth earnings performance. In 1998, SunTrust Banks Inc. was forced to restate earnings after being accused of dipping into the cookie jar too much.

Now subjectivity in calculating reserves is making a comeback with the tacit approval of regulators and standard-setters.

“The regulatory approach has reversed with a focus on having sufficient buffers going into a crisis,” said Fitch’s Wolfe. “Looking into the future, there’s always going to be some subjectivity.”

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