A banking CEO recently made some scathing public comments about CECL. Is his view widespread? And what's at the root of banker with the accounting standard? We tackle those topics in this episode of The Purposeful Banker.
UMB Financial CEO Says CECL "Means Nothing to Me" (S&P Global)
Is Your Bank Ready for CECL? (PrecisionLender)
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Jim Young: Hi, and welcome to The Purposeful Banker podcast brought to you by PrecisionLender, where we discuss the big topics from the minds of today's best bankers. I'm your host, Jim Young, director of content for PrecisionLender. I'm joined again by Dallas Wells, our EVP of strategy.
Today's topic is CECL. But, before you yawn or immediately try to turn this podcast off, give us just a couple of minutes here, because I think you will find some recent comments made by a bank CEO in an earnings call to be pretty interesting. Or, at least intriguing. So the CEO in question is Mariner Kemper, he's the CEO of UMB Financial, a pretty big regional bank out of the Kansas City, Missouri area, and he made it during a second quarter earnings call.
Dallas, I'm going to just go through these choice soundbites here, from Mr. Kemper. Refreshingly candid, I'll just say that. Whether you agree or disagree, we'll get into. But, points for transparency.
"We're complying with CECL because it's an accounting convention we need to comply with. But it means nothing to me, as it relates to how I feel about the quality of my loan portfolio."
And then, just in case you weren't sure what he meant by that, he then doubles down with:
"CECL is a joke because the way every bank does it is different. It's a stupid way to analyze what the problems are in a bank's portfolio."
All right, so Dallas give me your instant reaction. I will just say, as an aside, I shared this with another banker last week when I saw this article, and his first response is, "Well, I imagine he'll be getting a visit soon from some government regulators." What were your thoughts, when you saw this?
Dallas Wells: Well, I couldn't help but think of Michael Corleone, where basically Kemper is telling CECL, "You're dead to me. You mean nothing to me."
I think what he's saying is probably a pretty common thought within the industry. He's saying, "This is an accounting thing, and an accounting thing only." There's been a lot of focus on that particular number, because the first quarter was when most banks actually started using CECL. There was all kinds of wonkiness in the financial reporting because of it, so there was lots of analyst questions about it. And they said, "Hey, you made a giant loan loss reserve. Is that because you see some ugliness coming, or is it because of CECL?"
So this is a question that the bankers are tired of getting, and it puts some of their credit quality into question at a very bad time. There's lots of unease out in the street about bank credit quality, rightfully so, and so to have this happen at the same time is the worst possible timing. You can hear the frustration coming through there, of now there's this thing that, in his mind, this is for the accounting nerds to deal with and it's irrelevant. But, it ends up taking up a lot of time on his earnings call, and seeding some doubt about what UMB looks like going forward, so totally get the frustration.
Jim Young: It sounds like though ... Is he directing this towards government, for coming up with this thing? Or, is he maybe chastising a little bit an analyst, and saying, "Stop focusing on this number because it's actually not a good way of measuring what we're doing as a bank?"
Dallas Wells: I think it's both. I think they're frustrated with the analysts for not hearing what the banks have been shouting about for the last couple years, as they've gotten ready for this. Which is, "This is not going to be a true picture of what we think the real issues are."
I think, really, it's some frustration with regulators for adopting this, and that's probably why the other banker you talked to said, "Well, they're probably going to be getting a visit," or at least a phone call. It's like bad press in their mind of, "Hey we're trying to roll this thing out. Could you tone it down a little bit?" But the bankers have not been quiet about this, they've been pretty direct in that they think this is a bad idea. They think it's really expensive to put together, it's a lot of effort to come up with a number that, again, they don't think is the real picture.
This is related to lots of other accounting issues for banks, where the regulators are pushing banks to have this mark to market view of their balance sheet. In their ideal world, I think they want banks to be able to say, "On a pro-forma basis, from here going forward, this is what we think the value of everything on our balance sheet is," and that changes in real time, and it's this forever forward looking view. The bankers are saying, "That's just not practical, there's way too much modeling, there's way too much uncertainty."
To his point here, every bank's going to do that a different way, so what's wrong with the metrics we've been using? As a way to really gauge where the bank is, let the bank deal with its issues in real time. CECL's just the latest version of that, where the regulators are asking for a little more transparency in what do you think the future value of this thing really is, forever and ever. Permanent impairment, we want you to realize that now, instead of slowly realizing that pain over time. So just the latest in a long string of these disagreements, fundamental disagreements about how we measure the business.
Jim Young: Right. So I'm trying to think of how to ask these questions here, without getting us on one side or another because there's definitely some hostility.
I guess, what I'm wondering is, in general, some of this regulatory stuff doesn't come out of thin air. There's a reason for what's triggering this ask, whether or not the ask is realistic is another question. I guess I'm wondering is let's just keep doing it the way we used to do it really a fair response from bankers?
Dallas Wells: Let's back up and look at industry wide. I'll say, first of all, as a caveat, you can see why UMB might have some frustration with this. They're historically a pretty sound bank, they've been run by the Kemper family for multiple generations now. They're solid, right? That's his point is, "Hey, don't we have some credibility here?" For that individual bank, they do. You see why he doesn't want to have to deal with this nonsense, the way they've been doing is working.
As an industry, though, that's not always the case. And that's the way the regulators have to look at it, is with this broad brush. Unfortunately, the good apples have to put up with the tests that we're going to put in place to find the bad apples, is really what it's about.
So what they're after, if you look at bank that's struggling, they don't want to have to say, "Oh man, a big chunk of our portfolio just soured." Let's say, right now a bank has big exposure to the restaurant and hotel industries, that's probably bad news. So if they have to say, "Well, realistically that's a 30% write down on that portfolio, and then we're out of business." They don't want to view it that way. They would rather say, "We had net charge offs of $40 million this quarter. We can put $40 million, plus maybe some extra, into loan loss reserves, and we can slowly, over time, earn our way out of this." So you realize the impairments as they actually land at your door, instead of trying to evaluate your total portfolio and say, "All future losses, we have to eat them right now." Instead, they want to do that over time.
From the regulators' perspective, that is the classic extend and pretend, kicking the can down the road, you're just hiding the real, true extent of the issue. The fairest way for shareholders and depositors who have a stake in this, is for them to be able to see where do you really stand right now, what do you know about your business that you should communicate to everyone. I think that's fair.
Between the industry and between the regulators, there may be some disagreement on how to get there, but I think philosophically that's where the regulators are coming from, and I don't think that's a bad place to be coming from. You see why they want to do that. If a bank is going to fail, let's admit that now and reduce the extent of the losses, and give people time to adjust to that, rather than we slowly realize it over the next five years.
Jim Young: Okay. I'm going to make every possible attempt to keep us out of a discussion that goes into the weeds of accounting, mainly because I wouldn't even know where to start that discussion. But, if we agree that the intent makes sense, then, but that there's possibly issues in the execution of it ... I'm trying to figure out if I want to put you in the shoes of the analyst, the regulator, or the bank CEO here.
But for now, let's go with bank CEO, and say all right, put aside what the government wants you to do. If it's a good idea, this idea of this forward looking thing, what are the ways that you would measure it? Kemper mentioned, "Hey listen, I just want to have non-performing loan coverage and net charge offs. That, to me, is going to tell me what I need to know." If you're in his shoes at a bank, is that going to tell you what you need to know? Or, is there something else you think needs to be in the mix?
Dallas Wells: Well, I think the nuance here is he's questioning analysts looking at CECL numbers from two different banks and trying to make a comparison between the two. He's saying because their methodologies can be very different, and their assumption sets can be very different, even if internally that's a fair indicator of what of that bank really thinks, it's not an apples and apples comparison between banks. Whereas non-performing loan numbers, how much is past due, how much is on non-accrual, how much did you charge off my category, that's the reality of the way a bank actually realizes losses. There's a slow deterioration, and then eventually they're behind by 30 days, 60 days, 90 days, they're put on non-accrual, you go and recover that. Some amount of that will get charged off.
The argument of we should realize this loss over time, that's the reality of how the losses show up. It's not this title wave that you get hit all at once, it's this trickle over time. That's the best universal way to look between banks, and within a bank maybe, even to look between product types, between different markets, between what different relationship managers portfolios are experiencing, is some universal, easy to measure number, where the criteria is pretty straight forward. These black box models, it's difficult to make those comparisons, and make sure that you're getting a good signal between those things.
I think his classic credit metrics, they will always have a place in analyzing a bank. And even if CECL earns a place at the table in those discussions, it doesn't replace those others, and it doesn't become this one metric for everyone where you can make these easy comparisons, and just instantly know where a bank stands.
Jim Young: All right. So, you've got this discussion of, "Hey, this is an apples to oranges thing that you're trying to judge us by," and that is an analyst view of bank health. I guess, what I'm also wondering then is, an analyst's version of health is different from a bank CEO's version of health, right?
Dallas Wells: Yeah.
Jim Young: There's one, is this a good thing to invest in, but then there's a bank CEO of are we going the right direction, is our portfolio going to look good four years from now? Or, are those the two? Can they be the same thing, I guess? Or should a bank have a different way of looking at it?
Dallas Wells: That's a good question. I think what's you're getting at ... I'll paraphrase it a little, and let me know if I'm on the wrong track here. But, those classic credit metrics are backwards looking things. So tell me, as of today, what's already past due? What's already a problem?
What CECL is trying to do is look forward. It's your current expected credit losses, that's what it means. Actually, we use a version of that as part of our standard PrecisionLender methodology, as we are looking at risk adjusted profitability, on a relationship, on an individual transaction. We want to measure how much do we expect to lose from a credit lose perspective, on this particular deal. It's the probability of default, how much are you going to lose if it does default, and you bake that into how profitable the deal is. It's this forward looking metric that is absolutely valuable in evaluating a new transaction, in evaluating where you are with a customer.
And again, we almost always focus on that pro-forma because that's the stuff where you can make decisions. It's not to necessarily measure where you've been, but measure where are you today, and where are you going forward. I think where the disconnect comes is an earnings call is not about pro-forma, it's about what happened last quarter. So now, they're crossing the streams. CECL has value, that concept has value, but to plop it down in an accounting world that is still backwards focused ... How much interest income did you accrue last quarter, how much interest expense? And then, how much did you write off on in bad loans? Now they're saying, "Well, on top of that, how much do you think you're going to write off in bad loans?" The bankers are saying, "I don't get to realize what I think I'm going to earn on those loans, so you're asking me to take one side of that. I have to realize what I think is going to happen in terms of losses, but I don't always get to count the same expected income."
It does have a lot of internal value, but it is the crossing of what's forwards looking and what's backwards looking. Bankers tend to be ... If we're to make a criticism of the industry, and one that we still run into a lot as we work with banks, it's that they're really, really good at looking backwards. That's been the core of the business for a long time, is keep track of the debits and credits, and that's the table stakes for a bank is you can store value there and you know it's going to be tracked properly. Guessing where things are going to happen, properly measuring those, recording those, making good decisions around those, there are some bankers that are good at it, and there's a whole lot that just aren't. Those are just two different skillsets, two different concepts.
I guess, maybe the way I would put it is when I was a banker, I would get occasional phone calls from headhunters looking for CFO candidates. I could tell a lot about the bank by the requirements for that job. Some of them would say, "CPA required, we want you to have an accounting background." That, to me, is a bank that's going to be focused more on the backwards looking, reporting, and tracking where you've been, versus a bank that doesn't care as much about that, and they're more about the finance side of things. Tell me what's coming, let's make strategic decisions about what's ahead. Those are both important jobs, it's just that you need to know which one you're talking about.
That's the same question here. When you're measuring what's going on inside of a bank and their credit issues, you need to know everything that's backwards and the trends there, but those are to inform the decisions you're making going forward. That, to me, is where CECL has value, is in that forward looking decision making process, and that's how banks should embrace that piece of it. Yes, it's frustrating that it's including accounting, and now it impacts your quarterly earnings, you're just going to have to deal with that. But there are good things that come from it, that you should embrace. Use that methodology to make a healthier credit portfolio, and incorporate it into some of your decisions of how you allocate your capital. That part's valuable.
Jim Young: Yeah. Basically, the heart is in the right place on this, I guess.
Dallas Wells: Yeah.
Jim Young: But, it's just a typically government ... Part of it is just the nature of it, like you said. Kemper even says it, "We all do it differently," and that sort of thing, so trying to put a universal mandate across this sort of thing is, by its nature, going to be clumsy, and rigid, and all those sort of things. But that doesn't mean that the idea behind it doesn't have value for banks. Maybe it shouldn't be an earnings call centerpiece, but it doesn't mean you should ignore it, basically.
Dallas Wells: I think that's what it comes down to, and I think that's probably a pretty common sentiment in the industry. Look, we're not arguing the concept, just why are you making me report earnings this way? That seems silly, and it seems like a piecemeal approach to that pro-forma view that you're wanting to include.
Jim Young: Gotcha. I've got one more question that I'm just going to throw in here. This could be a broad, existential question so we'll see where it goes. You mentioned the whole looking backwards sort of thing, and that's the way that banks tend to operate. This is an out of a comfort zone, asking you to look forward and tell me what you expect to lose on something, and that sort of thing. Again, layperson question here, but every time you make a loan, you're essentially looking forward, right? If you're telling me that banks aren't very good at this, I feel like you just told me they're not very good at making loans and that concerns me.
Dallas Wells: Yeah. I think they are, it's that there's some concepts of properly allocating a balance sheet, and being forward looking. Things like opportunity costs, that's something that you have to consider if you're looking at what's the best use of this dollar of equity that I have at the bank, I'm going to invest this in something. A lot of bankers, I won't make a universal statement there. But, a lot of bankers will want to look at that and say, "Look, I made money on this. It was a profitable transaction, so why are there these hurdle rates in place? Why do I care about the cost of that capital? Yeah, there's may be some other profitable business out there, but I generated some dollars of net income, aren't we happy?" That's just not really the case.
After the financial crisis, and as we go now through another probably ugly credit cycle, capital always becomes the ultimate constraint. It doesn't feel like it is in the good times, but in the bad times capital is always, always the constraint. That means that's the thing that we have to make the best use of. That's why you see banks that want to measure everything in terms of spread. "Hey, I made 200 basis points on that loan, what's the big deal?" Well, you had to allocate a ton of capital to it, to generate that. What if I could have generated only 100 basis points of spread, but I only had to use a small fraction of the capital to generate that? Now, I can take the rest of that capital and go do something else with it.
It's optimizing what you're doing with each dollar. Any asset that you invest in, and that includes any loan that you make, every dollar that goes out the door with that is a dollar that can't be used for something that maybe would have been better, maybe would have been more profitable, maybe would have been safer, whatever the case may be.
Those forward looking concepts are the ones that ... It's not that banks are making bad decisions where they're making a ton of bad loans, the statistics say that they're not. There's going to be bank failures, and there's going to be cases where that happens, but by and large, bankers are good at making loans where they get paid back. Does that mean that that loan was the optimal use of that capital? That's where it's not always the case, and that's where there are some banks that are really, really good at that, and there are some that are okay. They get their money back, but they could probably do better on it. That's where you differentiate between really high performing banks, and banks that are just doing okay.
Jim Young: Gotcha. Okay, well thank you. I feel a little bit better, then, about it.
Dallas Wells: Good.
Jim Young: I feel pretty good that we got through the CECL podcast without really going super deep into CECL in this one.
Dallas Wells: I think that was a requirement coming in, because that's not a place I want to wade into, and I'm sure you don't either.
Jim Young: Yeah, just a little behind-the-scenes for people, Dallas had somewhat of a "Mariner Kemper", very blunt assessment of this podcast topic.
Dallas Wells: I'm not talking about CECL.
Jim Young: CECL?
All right, that'll do it for this week's show. Dallas, thanks for coming on and embracing the topic of CECL.
Dallas Wells: Yeah, thanks Jim.
Jim Young: All right.
Now, for a few friendly reminders. If you want to listen to more podcasts or check out more of our content, visit our resource page at precisionlender.com, or head over to our homepage to learn more about the company behind the content. If you like what you've been hearing, make sure to subscribe to the feed in Apple Podcast, Google Play, or Stitcher. We love to get ratings and feedback on any of those platforms. Until next time, this is Jim Young to Dallas Wells, you've been listening to The Purposeful Banker.
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