Congress Is Threatening to Make the Next Financial Crisis Worse

(Bloomberg Opinion) -- 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 has several advantages. It 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 sheds light and imposes discipline beyond the traditional banking system — where the most aggressive mortgage and corporate lending is often concentrated.

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. Much of the world adopted the new standard last year, with little difficulty. The Financial Accounting Standards Board took several years to develop its version, holding dozens of meetings with the relevant parties, reviewing more than 3,000 comment letters, and making alterations designed to ease the burden on smaller banks. The “Current Expected Credit Loss” rule was finally completed in 2016. If it starts to go into effect as planned next year, all the affected companies will have had more than three years to prepare.

True, provisions will depend on the forecasts lenders use. But a study by Moody’s Analytics found that even with a typically imperfect economic forecasting model, the rule would have worked as intended if it had been in place during the 2008 crisis: Thanks to the smoother profile of provisions, credit would have been tighter during the boom and easier during the bust than under the old rule.

Scuttling the reform at the last minute would leave the U.S. out of sync with the rest of the world and the make the financial system more vulnerable to the next downturn — just as the Trump administration is weakening other protections. Legislators should let the new rule stand.

Editorials are written by the Bloomberg Opinion editorial board.

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