Adoption of the CECL accounting standard in 2020 has increased the complexity of the reserve estimation process and the volatility of reserve model output.  The complexity of the reserve calculation was increased due to the requirement to incorporate a reasonable and supportable forecast into the reserve process.  Although some aspects of the CECL accounting standard reduced complexity (e.g. removal of the SOP 03-3 purchase accounting rules), the inclusion of a forecast has caused the complexity of the reserve calculation to increase while decreasing comparability between banks due to each bank’s idiosyncratic approach to forecasting.

Reserve model output volatility has increased since the adoption of CECL.  The onset of the pandemic coinciding with the adoption of CECL in 2020 exacerbated the inherent procyclicality of the accounting standard.  The severe economic downturn seen in the first half of 2020 caused reserve rates to climb sharply without a commensurate increase in defaults or losses.  This increase in volatility was caused, largely, by the macroeconomic forecasts at the time being dire.  With the rapid recovery seen in the fourth quarter of 2020 and throughout 2021, reserve model output fell just as rapidly as it rose due to the actual and forecasted economic conditions.

How has macroeconomic uncertainty contributed to the total level of credit risk seen across all loan categories?

Macroeconomic uncertainty has increased perceived risk across all loan categories; however, calculated credit risk, as seen in transaction level credit models, remains low.  This divergence in expected, and calculated credit risk is driven by two primary factors: the use of financial statements (an inherently backward-looking measure) and payment performance.

This divergence could converge if expectations become a reality through an increase in defaults and losses as the macroeconomic uncertainty turns into a depressed macroeconomic reality.  This perceived increase in risk that is caused by macroeconomic uncertainty then becomes a self-fulfilling prophecy as lending standards tighten, drying up the availability of credit.

Which loan types are impacted first by increased interest rates and tightening credit conditions within the banking system?

As the Fed increases short term interest rates and tightens credit conditions, loans to individuals that are secured by residential properties and commercial loans to homebuilders can be among the first to come under pressure.  Although delinquencies have not increased markedly yet, some borrowers in the industry are beginning to pay more slowly.  If credit conditions tighten further and unemployment rises, housing sector related defaults are expected to rise.

Tightening credit conditions, so far, have not had a material impact on commercial lending defaults or losses.  Credit quality continues to look good as these loan types are underwritten with substantial cushion in their debt service coverage ratios, allowing for increased rates to not have an outsized impact on payment performance.  However, if conditions deteriorate in the economy more widely as a secondary effect of increased rates, profitability will be hurt and could lead to increased defaults and losses.

Do you see the removal of COVID protections as a material source of credit risk to the banking system?

Removing COVID protections will not create a material source of credit risk in the banking system.  Although the initial level of payment deferrals was high during 2020, subsequent rounds of deferrals were not used as widely.  The large uptick in economic activity seen in 2021 and 2022, compared with 2020, has allowed for many small and medium sized businesses to swing back to profitability and resume their normal course of debt repayment.

Although a material increase in credit risk in the banking system is not expected due to COVID protections being removed, the consumer lending segment may be impacted once the student loan repayment pause ends.  It is currently set to expire in June 2023, with payments to resume 60 days later.  With increasingly leveraged consumers, an increase in required debt payments from existing student loans could increase borrowers’ overall credit risk.