The Current Expected Credit Loss (CECL) model has gone through final deliberations at the Financial Accounting Standards Board (FASB); the dramatic impact of this change on loan accounting for banks of all sizes will be far reaching.
The Financial Standards Board
Bank accounting has historically been challenged with how best to account for troubled loans. The financial disarray of 2008 significantly added to the desire of both the Financial Accounting Standards Board (FASB) as well as U.S. and international regulatory bodies to enact a better process for the estimation of potential credit loss within a portfolio of loans.
Hence, in 2012, the FASB set out on a course to remedy loan accounting treatment via a project related to the impairment of financial instruments. The FASB teamed up with the International Accounting Standards Board (IASB) on a joint project aimed at assisting financial institutions with estimations around allowance for loan losses.
This proposed accounting change will have dramatic impacts throughout the industry, requiring significant operational changes, as well as data management and systems changes that are still being contemplated, as banks consider the implications of the new model prior to implementation.
The sweeping legislation is perhaps the largest change to bank accounting in decades.
While everyone would agree that improved methodologies for the recognition and measurement of credit losses for loans and debt securities is a good idea in theory, there is industry angst around how sweeping the operational and process changes will be, and how costly a proposition this can become.
How Did We Get Here?
Technically known as Accounting for Financial Instruments – Credit Losses, (Subtopic 825-15), the accounting change came about as a result of a desire to improve investor ability to comprehend bank financial statements.
The FASB stated their objectives as follows: ”The objective of this project is to significantly improve the decision usefulness of financial instrument reporting for users of financial statements. The Boards believe that simplification of the accounting requirements for financial instruments should be an outcome of this improvement. The Boards’ goal is to develop a single credit loss model for financial assets that enables more timely recognition reporting of credit losses.”
What drove this change? The need for an improved loss model to replace the “Incurred Loss model”, an interest in the international banking industry to have a common standard, and lastly the 2008 financial crisis all served to fuel the desire to put forth this new standard.
The impact of the financial crisis significantly increased the regulatory scrutiny related to the timing and recognition of credit losses on financial instruments, as well as to the overall adequacy of reserves established by financial institutions that are reported in bank financial statements.
As such, the FASB set out on this course of revising practice regarding credit losses, with a hope of correcting a perceived weakness in the existing incurred loss model.
The objective is to move away from a model that doesn’t recognize credit losses until a loss is probable, and toward a model that utilizes more forward looking information.
CECL is a fundamental change to the way banks estimate losses within their loan portfolios. Existing bank methods for loss accounting is based upon an “incurred loss” basis; said another way, banks currently do not have to estimate potential losses on a loan unless the losses are probable and reasonably estimable.
The FASB proposed approach, by way of comparison, is an “expected loss” methodology. In its simplest terms, this approach requires a credit loss to be booked for accounting purposes at the origination of a loan, based upon what is expected to happen many years in the future. For practical purposes, both models can be performed at the portfolio level, using historical loss performance as an anchor point.
Given the scale of the proposed change, the FASB has tried to manage some of the many misunderstandings that come with such a drastic change in practice. Of primary concern among industry participants, in addition to the operational changes necessary, is the potential for large increases to banks’ allowance for loan and lease losses.
CECL Implementation Timeline
Originally proposed to the industry in December of 2012, the CECL rollout has encountered numerous delays and industry discussions, as the accounting board seeks input to ensure that the intent is realized through implementation.
The proposed legislation has gone through multiple iterations, and been put out for industry feedback comment period, as well as roundtable discussions. There have been dozens of comment letters sent to the FASB from industry participants regarding concerns with implementation.
With the FASB’s recent finalization of the legislation now in place, the formal implementation timetable varies slightly, depending on a bank’s SEC registrant status.
For SEC registrants, the implementation of this new standard is set to commence during the 2020 financial statement period, and for non SEC registrants, it will be implanted during the 2021 financial statement period.
What are the Market Impacts?
Data Management is Pivotal
As part of this change to loss estimation, organizations will have to be very focused on data management. Entities of all sizes will need to do an assessment of required field level information, and to the extent data collection, assimilation, cleansing, and organization need to be improved, will need to have a well thought out program to enhance their ability to turn data into information.
Forecasting Methodologies Will Need to Change
Loss estimation methodologies for financial services firms of all sizes will need to be modified.
While in some respects the new requirement will simplify accounting treatment (for instance, impaired assets and non-impaired assets will no longer be treated separately), methodologies for life of loan loss estimation will take on a new dimension.
Entities that are better suited for the assessment of historical loan loss performance, the ability to review origination year cohort performance, and those that have the most efficient methods for predictive analytics will have a distinct competitive advantage over those that are less sophisticated.
Process, Process, Process
Like most paradigm shifts of this magnitude, a well-documented game plan for conversion is mandatory. A thorough, documented, supportable, auditable, and repeatable process will be critical. Requirements, methodologies, systems inputs, roles and responsibilities, review and approval methods, will all need to be transparent throughout the organization, in order to appease the financial statement auditors and regulators alike.
About The Author
William Vahey is a Senior Managing Director with RiskSpan, and leads advisory engagements for the firm at multiple financial services organizations throughout the country.