Based on a study I completed, I predict the worldwide availability of bank lending will shrink by $2.6 trillion dollars in 2019 when banks transition to the new lease accounting rules (Topic 842 in the U.S. and IFRS 16 for the rest of the world).
The Basel Committee, responsible for setting international capital rules, decided the ROU operating lease assets require capital. The Controller of the Currency and Federal Reserve, responsible for setting U.S. bank capital rules, tentatively decided to go along with Basel’s decision. Although the OCC and Fed have the power to differ on behalf of U.S. banks, they do not seem to be so inclined. This means banks will have to apply 10.5% capital to those new assets. Currently, operating leases are executory contracts not recognized on the balance sheet, with no capital required for both U.S.- and foreign-based banks. I predict banks will cut back on lending to address the new capital need.
How Do the New Lease Rules Affect Bank Capital?
Banks are heavy users of operating leases, primarily for their real estate branches and office space leases. They cannot avoid most branch real estate leases because it would be impossible to own the real estate they use in their business since branches are generally located in city store fronts or mall locations. Leasing also provides the flexibility and avoids the risk related to owning real estate. Banks also lease equipment, primarily ATMs, computers and office equipment.
Operating leases are executory contracts under commercial law, which are off balance sheet under current GAAP. U.S. commercial bankruptcy liquidation law for equipment leases requires the asset to be delivered to the lessor and extinguishes the future lease liability, so there is absolutely no bank capital risk.
For real estate branch leases in a bank bankruptcy, often the branches are purchased by another bank (arranged by regulators) which assumes the leases. In the worst case, where no assumption takes place, and if a lease is rejected in bankruptcy, the landlord’s damage claim for termination of the lease will be treated as a pre-filing unsecured claim. The damage claim for future rent under the lease will be capped at an amount equal to the greater of one year’s rent or 15% of the remaining lease term (up to a maximum of three years of rent) calculated from the earlier of the date the bankruptcy petition was filed or the date when the landlord recovered possession of, or the tenant surrendered, the premises.
This ability to cap a landlord’s claim in bankruptcy is often a major benefit to a debtor tenant, especially when it involves a long-term lease with rent obligations higher than current market rates. As a result, the bank capital risk for a real estate lease is minimal and should be reflected in a low-risk weighting of 10% to 20% of the ROU asset amount to keep it simple. Another option would be to conduct a lease-by-lease risk weighting with equipment leases weighted 0% and the real estate risk weighting adjusted for the individual lease’s term and the probability that the branch will not be acquired by another bank.
The new lease accounting rules will put a new operating asset and liability on books equal to the present value of future lease payments, but the new rules do not change the risk profile of operating leases. That new asset will attract regulatory capital of 10.5% unless U.S. regulators change their minds. The regulatory capital is designed to be a cushion against losses in liquidating an asset in bankruptcy liquidation so creditors can recover their financial claims, but I think the regulators have not considered the treatment of operating lease assets in bankruptcy.
IFRS 16 presents two additional capital problems for internationally-based banks because the IASB decided to treat operating leases like financed purchases or finance/capital leases with a front-ended cost pattern versus the operating lease straight line average rent cost pattern under current IFRS GAAP. The front loading is due to lease costs being the sum of straight line depreciation of the asset plus imputed interest on the liability, which results in a pattern of costs that declines over time. Generally, rents are tax deductible as incurred, typically on a straight line or back-ended pattern where rents step up. This creates a permanent loss of capital since the timing difference will never turn around as new leases will replace old leases. It also creates a permanent-deferred tax asset, which attracts regulatory capital. This cost pattern will affect international banks twice as heavily as U.S. banks. The cost pattern for U.S. banks’ operating leases under Topic 842 will be the straight line average of rents under current GAAP.
What is the Impact of the Increased Capital Needs?
The effect on any one bank is generally less than 1% additional assets coming on balance sheet and less than 1% more capital needed. But in the aggregate, I predict the impact to all banks will be significant. As an example of an individual U.S. bank, Bank of America will add $11.2 billion in ROU operating lease assets, requiring $1.2 billion in capital — an effect of less than a 0.5%. As an example of an internationally-based bank, Deutsche Bank will add $3.2 billion in ROU operating lease assets and $0.2 billion in deferred tax assets and will have a capital loss due to the cost pattern of $0.3 billion. The total capital need is $0.7 billion, or 1.1% of current capital. I estimated amounts for these banks using their operating lease commitment disclosures to make the calculations.
I studied a sample of U.S. banks representing 19% of the U.S. market. Extrapolating the results, I estimate the effect in the U.S. will be $134 billion in new ROU assets. For internationally-based banks, I estimate the equivalent of $2,416 billion in new assets added. The effect on internationally-based banks is about twice as high as it is to U.S. banks, and I estimate the U.S. bank market to account for about 10% of the worldwide bank market.
When I raised this capital issue with the IASB staff, the OCC and FED, they said the effect on any individual bank is not material. But as Senator Everett Dirksen once said, “A billion here, a billion there. Pretty soon, you’re talking real money.” I think $2.6 trillion in new non-earning bank assets added at once will have a significant effect on the worldwide availability of credit.
What Will the Banks Do to Address Capital Needs?
In 2019, bank CFOs worldwide will deal with the capital need for $2.6 trillion in new assets, which equates to $277 billion in new capital needed. The banks have four options:
What is the Solution?
The simple solution in the U.S. is for the OCC and FED to risk weight ROU operating lease assets at 0%, indicating they have little to no impact in liquidation and continuing current practice. Alternatively, they could choose a low percentage (5% to 10%) to reflect the treatment of real estate operating leases.
The FASB intended to give users like regulators enough information to continue treating operating leases as before despite the change in financial presentation. The FASB does not agree with the OCC and Fed decision to have operating lease ROU assets attract capital. Jim Kroecker, FASB vice chairman, spoke at the Equipment Leasing and Finance Association’s annual Lease Accounting conference in September 2017 and said, “I was personally disappointed. I explained very clearly that there is no change to the economics one bit. Don’t use our standards to say suddenly the regime has changed…Don’t opportunistically pin something to our standard. This is the right change. We explained why this is the right change.”
The answer for international banks is not that simple as IFRS 16 does not require lessees to break out ROU assets by operating lease and finance lease type. It would require keeping a second set of records to get the breakout. This capital cost to the international banking system may not have been accurately factored into the cost benefit analysis of the IASB method of accounting for leases by lessees.
Regulators who rely on GAAP treatment of assets and liabilities have to start to look into the nature and substance of assets and liabilities as the FASB and IASB are moving away from the traditional legal-based risks and rewards analysis that define assets and liabilities. Both the lease standard and the revenue recognition standard are putting assets on balance sheet that are not legally owned and not subject to bankruptcy liquidation. The regulators have to revisit their processes and adjust as they can no longer count on GAAP’s definitions of assets and liabilities. Failure to do this creates erroneous capital needs.
I also expect the recent accounting changes to loss recognition in a troubled debt restructuring and the transition in 2020 to the current expected credit loss (CECL) model to negatively affect capital and add to the cutbacks in available bank lending. I cannot argue that the CECL and troubled debt restructuring acceleration of loss recognition are not proper, but the change in capital rules for operating leases is wrong.