Time-varying capital ratios under CECL

We investigate how to design time-varying capital ratios under CECL accounting to maximize joint surplus of debtholders and equityholders of a bank. In stark contrast to the Basel III Accord, we highlight the role of intertemporal connections to design capital ratios that vary across business cycles. We derive two main results. (1) The optimal capital ratio is tighter for anticipated cycle turns and looser for anticipated cycle persistence for highly levered banks relative to the benchmark of absent intertemporal correlation of shocks to loans. (2) The optimal capital ratio is looser for an anticipated downturn and tighter for an anticipated upturn relative to the benchmark of absent intertemporal change in liquidity demand for deposits. Comparing the CECL model under U.S. GAAP with the ECL model under IFRS shows that the optimal capital ratios are more stringent under ECL than under CECL. Nevertheless, both models yield identical equilibrium risk-shifting incentives for banks.