More than a decade after the 2008 financial crisis, the U.S. is finally on the verge of adopting a much-needed reform designed to make the system more resilient.
Note to Congress: Please don’t get in the way.
The reform involves an accounting rule that played a big role in making the crisis worse than it needed to be. It effectively prevented banks from recognizing bad loans until losses were “probable” - meaning that payments were already well past due.
This left banks’ books out of touch with reality, to the consternation of regulators, investors and even the banks’ own executives. The losses ultimately came all at once, impairing financial institutions’ capacity to make new loans when the economy needed it most.
After that debacle, the Group of 20 developed and developing nations tasked accounting standard-setters with developing a better approach.
Their solution: Require lenders to look forward, building provisions based on how much they expect to lose over the lifetime of a loan. Under the new standard, loans with risky features such as low down payments or weak investor protections require larger provisions upfront, even if the borrowers are paying on time. Companies must also publish added information on their loan portfolios and the models they use to forecast performance.
This approach can smooth the financial cycle by encouraging institutions to provision more in good times, leaving them better prepared for bad times. It restrains irrational exuberance by making lenders think harder about risks at the outset. And it applies to all kinds of lenders, so it imposes discipline beyond the traditional banking system.
There’s one big downside: Earlier provisioning limits payouts to shareholders, because it cuts into initial profits and can require added capital.
Hence, financial industry lobbyists have long opposed it, arguing in part that it could lead to undesirable swings in provisions as economic projections alternate between excessive optimism and pessimism. And in recent months, they’ve garnered some support in Congress: Legislators have introduced bills in both the House and Senate that would block the standard and order regulators to prepare an in-depth study of its potential effect on lending. It’s hard to see what further study would achieve, other than further delay.