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No Bank Will Be Exempt from CECL

  • by Keith E. Monson
  • Feb 10, 2016

Five Ways All Banks Can Prepare Now for FASB’s Final CECL Framework

Let’s own it, as bankers we like to be in control, so uncertainty stresses us out. And when that uncertainty threatens our capital position and spans multiple years, our anxiety reaches a fever pitch.

Such is the case as the financial industry waits for the Financial Accounting Standards Board (FASB) to issue its finalized Current Expected Credit Loss (CECL) model. More than three years after its currently-proposed CECL model was published, the FASB is expected to issue its final guidance in first quarter 2016. And whether that expectation is fulfilled or delayed once again, it’s time to take back control.

It’s true: CECL will fundamentally change the way our entire industry accounts for loan loss reserves. No institutions are exempt from this, despite some lingering assumptions to the contrary. All banks must adjust their data collection and parsing to comply with CECL guidance, and they will take a potentially significant, one-time hit to capital when that change goes into effect. But while you’re waiting for the FASB’s final word on CECL, there are five tangible things to do now based on what we already know.   

1. Educate Key Stakeholders

Just because CECL has been on the radar since the 2008 financial crisis, don’t assume that all the relevant parties in your bank understand its full impact. Even those who are aware of CECL may be operating under the impression that smaller banks will be exempt, as advocates in the marketplace continue to make compelling cases for such an exemption. As Jeff Gerrish of Banking Exchange argues, “no community banker makes a loan which he or she does not expect to get paid back in full.” While it’s true the more conservative lending approach of community banks helped them weather the crisis better than larger banks, the FASB doesn’t appear likely to change its stance on this issue.

So, who needs to be in the know? CECL will affect a wide swath of banking areas. At a minimum, CECL discussions should pull in such key leaders as the chief credit officer, chief financial officer, chief risk officer and chief information officer. Senior lenders also should be represented, as should the compliance officer and business intelligence officer (analytics and reporting). Finally, senior management must be involved in order to make effective budgeting decisions based on the impact CECL will have on their bank’s capital.

Big picture: what do they need to know right now? The level of detail and type of information departments need to know will vary by their function, but from a high-level perspective, they all need to understand the following key facts about CECL:

  • Background: The impact of significant bank losses during the 2008 financial crisis led the FASB and other regulatory agencies to the conclusion that banks did not have enough loan reserves on hand, particularly in the event of another severe economic crisis.
  • Currently-Proposed CECL Model: After much anticipation in the intervening years, the FASB finally issued its proposed CECL model at the end of 2012. As described by the American Bankers Association (ABA), it shifts “from the incurred loss model, which required a loss to be ‘probable’ before it was recognized, to the CECL model, which represents all contractual cash flows not expected to be collected.”  In other words, an expected loss model.
  • Final CECL Model: The FASB has indicated it will issue final guidance in the first quarter of 2016. To allay fears, the agency has suggested it will look very similar to the 2012-proposed CECL model.
  • Anticipated Implementation Dates: The FASB has indicated that the final guidance will be effective in 2019 for SEC-registered institutions, and 2020 for all others. This prolonged period between final issuance and effective date should give banks ample time to prepare. 

2. Understand the Difference Between the Old and New Models

The heart of the FASB’s CECL framework is the fundamental shift in the handling of loan loss reserves. With the old model for the Allowance for Loan and Lease Losses (ALLL), banks didn’t have to set aside money for loans in good standing—only for those that were slow or delinquent. That changes with CECL. Upon implementation of the new model, banks must set aside reserves for all loans, regardless of their standing. 

A closer look at the difference: The old model is based on incurred losses during a given 12-month period, while the new model requires banks to account for all expected losses over the life of each loan. The ABA calls this life of loan concept “the biggest challenge of CECL (since) credit losses expected over the life of the loan are effectively recorded upon origination.” And the new model applies these reserve requirements to loans, loan commitments and held-to-maturity (HTM) debt securities. 

3. Ensure Portfolio Records are Being Retained

A bank’s past loan data will be critical to an effective transition to the CECL model, because banks will need to pull from that data to calculate their historic averages for life of loan losses.  

Don’t assume the needed data is available: All core processors have the ability to retain both open and closed files, and CSI is maintaining such data for its customers in anticipation of CECL. If your core platform is managed by another provider, review your contract terms to make sure that the schedule for closed file destruction meets your needs in regard to CECL. If not, you should discuss a more appropriate schedule, because more data equals a more accurate historical picture—which from a regulatory standpoint under the CECL model, must be defensible and documentable. Missing data will make it harder to claim either. 

4. Expand Data Collection in Anticipation of CECL

Once your bank has ensured the maintenance of its past loan data, the real detail work can begin. The CECL model will look at more data fields than before, and banks will need to tackle this task on two fronts:

  1. Pulling the additional data fields for past and existing loan files
  2. Determining the most effective, cost-efficient way to gather these additional fields going forward

A sneak peek at the additional data fields: Don’t wait until the final CECL model is published to get started on this task. You’ll just be further behind in preparing for this huge change. Most experts believe that the final CECL model will include the same additional data fields as the 2012-proposed model. So, in addition to the data now collected quarterly for calculating the ALLL (charge-offs, recoveries, aggregate pool data, beginning balance of pool, ending balance of pool), banks must also anticipate collecting these data points:

  • Individual loan risk rating
  • Loan duration
  • Individual loan balance
  • Individual loan charge-offs and recoveries
  • Individual loan segmentation

5Begin Estimating Your Capital Impact by Building a Vintage Model

When the initial switch to the new model takes place, banks will take a one-time hit to their capital. Thomas J. Curry, Comptroller of the Office of the Comptroller of the Currency (OCC), has estimated the FASB proposal will require most banks to boost their allowance in the neighborhood of 30 to 50 percent, if applied today, while others suggest it could be even higher. Regardless, come 2019 or 2020—depending upon registration type—banks must be ready for downward pressure on their capital position. The best way to prepare is to build a vintage model, given your existing data and a combination of forecast variables.

Vintage model telescopes the future: Building a vintage model will give banks an indication of how big their capital hit might be, based on several variables. As the ABA indicated in a recent webinar, a vintage model allows banks to “compute and accumulate correlations over time under different conditions” and “assess and document how changes in factors appear to affect subsequent charge-off rates.”  

A model includes the following three elements, the first two of which are known and stable. The third can use any number of assumptions or variables to create a richer picture of what could happen to reserve levels in the future, based on such factors as varying unemployment rates or real estate prices. 

Vintage model elements:

  1. Existing portfolio, good and poor loans included
  2. Past economic conditions
  3. Future economic forecasts (national, regional and local)

Your ALLL will be Affected by CECL, But Smart Planning Can Ease the Pain

As a fundamental shift in accounting for loan loss reserves, CECL will require significantly more data collection and analysis. It will take banks time to determine the best method (manual spreadsheet or automated system) to accomplish this task and fully incorporate it. Fortunately, in consideration of these challenges and the corresponding impact to capital positions, the FASB appears ready to give banks that time. So, it’s up to your bank to use that time wisely, knowing that controlling the eventual pain of CECL lies in smart and early planning. 

Keith E. Monson serves as chief risk officer for Computer Services, Inc. (CSI). In this role, Keith maintains focus on CSI’s compliance initiatives to establish and build out an enterprise-wide compliance framework for risk assessment and reporting, issue management and other key components of CSI’s corporate compliance program.