On June 16, 2016, the Financial Accounting Standards Board (FASB) issued ASU 2106-13, finalizing guidance related to recognizing expected lifetime losses for certain instruments, commonly referred to as CECL.
Current Expected Credit Losses
CECL is an acronym for Current Expected Credit Losses, and is used as shorthand for the new GAAP requirement to include expected life of loan (LOL) losses in the allowance for loan and lease losses (ALLL) for instruments held at amortized cost, versus the current incurred loss model. This is a very significant change for banks holding held to maturity (HTM) loans and securities.
Given the impact on financial institutions, roll-out of this standard has been slow, and the implementation time-frame is extended. For calendar year-end companies, implementation is required for fiscal year 2020 for public companies that are SEC filers, and 2021 for everyone else. Early adoption is permitted starting in 2019. Upon implementation, the cumulative effect will be recorded as an adjustment to retained earnings (no income statement impact).
Generally, loss estimates will be larger, more volatile, and more impacted by subjective inputs. Processes need to be enhanced and well documented to get management, auditors, and regulators comfortable with the outputs of the process.
Here are the top 10 organizational impacts that need to be considered as part of your CECL planning:
#1 – Estimates of impact are diverse
Clearly the composition of your portfolio plays a significant factor in determining what the CECL impact will be to your loss reserve. While the general consensus is that there will be an increase in reserves, estimates run from as low as 2-3% to as high as 50-60%. Balance sheets with longer term assets will generally see a larger impact. Prepayment assumptions, which are factored into CECL, take on new importance for longer lived assets such as 30-year mortgages. Certain loan types, such as unconditionally cancellable lines of credit and renewable loans, should actually see allowance levels drop, as no losses beyond the contractual end date are permitted under CECL guidance, regardless of the unlikelihood of cancelling a line of credit or the likelihood of renewing the loan. Additionally, methodologies will have to take into account multiple asset classes, including commercial real estate and consumer loans.
While the required implementation date is several years out, RiskSpan recommends that clients begin to assess the impact and evaluate different modeling options in the near term. Internal and external parties are sure to be interested in what the impact will be, and the methodology employed could have a significant impact on the overall impact of adoption.
#2 – CECL guidance does not prescribe a loss methodology, however the current consensus leans towards implementing a discounted cash flow model
While many methodologies can be utilized, including vintage analysis, loss rate method, roll-rate method or a probability of default method, the discounted cash flow methodology looks to be the most reasonable approach based on CECL guidance, particularly for portfolios with longer term assets. While a discounted cash flow methodology may be more complex to implement, we believe this methodology will result in a more accurate allowance which most closely reflects the true economics of the financial instrument. This is primarily due to the present value discounting inherent in this methodology, whereas discounting is not explicitly considered in the other methodologies.
Overall, the FASB expects that the sophistication of the methodology employed be commensurate with the complexity of the institution, and that the methodology reasonably reflect its expectations of future credit losses. RiskSpan recommends that various modeling types and segmentation methods should be evaluated prior to the implementation to determine which methodology best suits your institution.
#3 – LOL models already in production will likely need to be modified to be utilized for CECL
If you currently have LOL models in-house, these models will likely need to be modified to comply with CECL. For example, many of these models include forecasts of new production as well as anticipated loan renewals, both of which are not included in the CECL calculation. RiskSpan recommends performing a gap analysis for any model being considered for CECL and that upcoming model validations consider the requirement of CECL.
#4 – Organizations need to prepare data and models for SOX review
Data sets and models that previously were not subject to SOX and financial reporting control testing will now need to be reviewed. Data storage needs will be significant, and current databases should be evaluated for auditability and scalability. Controls around the databases supporting the life of loan calculation may need to be enhanced to meet financial reporting expectations.
#5 – Accounting close processes will need to be enhanced
Whereas ALLL processes have historically been able to largely ignore originations occurring near the end of the accounting period, this changes with CECL and the need to book a day one loss upon origination. Banks have traditionally had very short closing cycles. Systems will need to provide the data necessary to book the lifetime loss potentially requiring origination systems to be enhanced to capture that data real time.
#6 – Data needs to be enhanced to support LOL loss calculation
Portfolio data covering a full business cycle will be needed to support CECL calculations. Ten years is a reasonable starting point to cover a full business cycle, but this could vary depending on your asset type. Ten years will include results prior to, during, and after the financial crisis. Additional history could reduce volatility in your CECL calculation. RiskSpan recommends starting the assessment of data gaps to be performed in the near term, and to develop project plans based on that assessment.
#7 – Credit disclosures need to increase significantly
Given the lack of prescribed methodology provided by CECL, disclosures on how you actually perform the calculation will need to be robust and include how the forecast was derived, the time period for which a “reasonable and supportable” forecast was determined, and when historical loss rates were utilized.
The historic relationship between loan level credit performance indicators (current delinquencies, defaults, LTV ratios, etc.) and the overall allowance level will not necessarily still hold going forward. Period over period improvements may occur (e.g. delinquency rates decrease), however these could be more than offset by a worsening change in the forecast. Disclosures will need to bridge the gap when this occurs.
A specific new requirement that credit quality indicators disclosures be provided by year of origination (vintage) will be required for SEC filers and are optional for non-public companies.
Overall, the level and sophistication of the disclosures needs to be commensurate with the complexity and size of your institution.
#8 – Allowance will likely be much more volatile, potentially necessitating additional regulatory capital buffers
Small changes to future forecasts will typically have significant impacts on the reserve. This could make the allowance significantly more volatile, and regulators may impose additional capital buffers to absorb this volatility. RiskSpan recommends evaluating capital impacts to determine if additional regulatory capital will be needed to compensate for the initial impact and the increased volatility going forward.
#9 – Assumptions will need to align with other processes such as ALM and forecasting
Assumptions used to calculate the LOL loss are expected to be aligned with those used for other forecasts within the institution (income forecast, ALM, etc.). Auditors and regulators will not look favorably on utilizing one forecast for CECL purposes while a different forecast is being used for other purposes.
#10 – Entities need to monitor changes from the Transitions Resource Group (“TRG”)
The FASB has established the TRG, made up of bankers, auditors, and regulators to address issues and questions brought to them associated with CECL implementation. While the LOL concept is unlikely to change, RiskSpan recommends that clients follow the activities of the TRG as specific implementation guidance is likely to be issued over the next several years.
CECL is a significant change from current practice, and will likely involve a significant effort for most institutions to implement. While the implementation dates are 3+ years away, we recommend beginning the evaluation and planning for this effort in the near term.
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