Today, financial institutions are all across the board when it comes to CECL compliance. Some institutions have already implemented the CECL accounting standard. Many are running through their compliance checklist. Still others have delayed adoption to focus on more immediate priorities.
Transitioning to the CECL accounting standard is a long runway with several steps before takeoff. Whatever your stage of the journey, it’s worthwhile to hone your strategy and prepare as much as possible now. Fortunately, we now have more data to inform your expectations and methodologies.
Read on for a quick overview of the current CECL compliance landscape and for lessons that the industry has learned from early adopters.
Delaying the “Estimated Impact of CECL on Regulatory Capital”
When the Financial Accounting Standards Board (FASB) announced the Current Expected Credit Loss (CECL) accounting standard, it was met with some confusion and frustration. After delays and pushes to repeal it, many institutions believed it might get canceled or modified in a significant way.
That didn’t come to pass. So, even before the COVID-19 pandemic, some institutions had already begun to transition from their previous Allowance for Loan and Lease Losses (ALLL) approach. Then, in July of 2019, smaller institutions gained a reprieve, with the requirement postponed until 2023.
In response to the COVID-19 national emergency, the CARES Act of 2020 enabled some banks to delay further. The Office of the Comptroller of Currency stated the following as a rationale for that recent delay.
“As recently as late last year, economic conditions appeared stable and the introduction of CECL was expected to have only a modest effect on operations. However, the additional uncertainty due to the introduction of a new credit loss accounting standard in a period of stress associated with COVID–19 poses a unique and unanticipated challenge to business operations.”
All banks must now follow the CECL standard by 2023. That may seem like a long way off, but effective implementation takes time and requires a step-by-step approach. With appropriate methodologies and procedures ready in advance, you’re more likely to have a smooth transition.
Assessing CECL Compliance Challenges
CECL shifts reserve calculation from the probable or incurred loan loss model to an expected loss model. The standard seeks to improve the pitfalls of the previous methodology that led provisioning to occur only at or after a downturn.
The standard requires provisioning potential losses in advance by setting aside a larger cushion. As the OCC states CECL affects “the timing and magnitude of banking organizations’ loss provisioning, particularly around periods of economic stress.”
To meet the shift, you can leverage some of the tools that your institution has used to account for ALLL. However, you must modify them to account for projections and other complexities of CECL guidelines.
The calculation requires a view of past, present and future. So, besides enough historical data and current economic and environmental factors, you must include “reasonable and supportable forecasts.” Estimates must consider the entire life of a loan to account for all losses and recoveries in that asset pool. Such estimates include prepayments and charge offs.
As a result, there is a lack of uniformity across financial institutions. There’s no universal model, and instead the impact and calculation depend upon variables like your portfolio’s makeup.
Even so, some common trends have emerged among early adopters. If your institution has not yet switched or you’d like to hone your strategy, consider the following lessons from the banks that have adopted CECL.
Major Takeaways from Early CECL Standard Adopters
Many institutions, especially larger and midsized ones, rolled out their CECL plans before the pandemic. Since then, CECL estimates have been volatile. The limited data points and unpredictable economic environment has made those “reasonable forecasts” even more challenging to calculate.
Impacts also vary between institutions. But you can take a few pointers from the early adopters as you consider your portfolio and compare it to peers with similar asset pools.
Expect an Increase in Provisions
Since CECL requires institutions to reserve for expected losses rather than incurred, it should hardly be a surprise that reserves often increase. Yet the significance of that increase depends on several factors.
When big banks first reported the impact of the transition in the fourth quarter of 2019, most of their reserves increased. Institutions with many acquired loans were more likely to have significant increases.
Institutions that primarily lend to certain industries may require more reserve builds than their more diversified peers. For instance, a consumer lender that focuses on the auto or oil industry might need to increase their reserve by 75% to 100%.
Smaller institutions should consider these trends in their calculations, though their losses may be more sporadic and infrequent. They can then factor this potential increase in the reserve calculation when considering their yearly budget.
Consider a Wide Range of Scenarios
Most adopters did not take COVID-19 into account, which resulted in severe volatility of CECL estimates. Going into Q2 of 2020, those estimates escalated dramatically before steadying over the third and fourth quarters.
Many that had already converted enjoyed the flexibility of raising reserves without having to work extensively with auditors and regulators on qualitative (Q) factors. This adaptability exemplifies CECL working as intended.
And yet, not all models performed as expected. The actual charge offs from the crisis such were not as high as one would expect, likely due to government stimulus. Accurately estimating risk has also been challenging. The economy remained relatively strong and banks’ losses might not have been what they were during the 2008-2010 crisis.
Many experts expect that these estimates will continue to normalize and decrease. But these difficulties exemplify the need to consider a wide variety of scenarios and model their impact on a given portfolio. These must include extreme forecasts that can fully stress-test the model. COVID-19’s impact also proved that you should remain flexible. You must adapt to situations that require it, rather than purely tying yourself to a model.
Provide As Much Historical Data As You Can
Data collection and input have been another source of strain for smaller institutions. Smaller institutions may have no losses for an extended period, and those that arise may be sporadic. By comparison, the losses from larger banks often smooth out over time. As a result, collecting historical data has become all the more imperative when calculating the forecast.
Institutions must know losses, balances of each pool, loan-level losses and recoveries at the loan level. This can be difficult, as some institutions must refer to hard copies or rebuild historical data while refining or buying macroeconomic data to connect to their own.
While ten years of data is better, some will have to make do with five. The further back your institution can go, the better your calculation will be. Automated tools linked through your core banking platform can simplify the process of locating and importing historical data.
If You Choose a Vendor, Consider Your Selection Carefully
Smaller institutions are not required to use a third third-party vendor. Such an expectation may be onerous if it already has existing processes in place to calculate the life of loan and project future credit losses. However, an automated solution can suit institutions that have limited internal resources or that wish to simplify implementation.
Since all this work takes time and resources, and there are several ways to model a CECL calculation, a CECL solution can guide you to compliance. The right solution will coalesce the data and apply the models that best suit your portfolio for you, thereby saving time and effort on your part.
If you decide to work with a vendor, look for one that provides transparency and flexibility. New ideas will continue to emerge, and best practices will evolve. As a result, simpler “one size fits all” solutions may have not have the capabilities and flexibility that you need. Bear in mind that ultimately, it’s your institution, not the vendor, that shoulders the risk.
Run the Model Parallel for Two to Three Quarters
Once you select your options and build out the calculations, run your CECL model parallel to your existing ALLL model. This process shows how the change will affect your institution by comparison. FASB does not require a specific methodology to calculate the ALLL under CECL. Parallel runs can help determine which method is appropriate for each portfolio segment.
You might consider running multiple models at once so that you can later select the ones that produce preferable numbers. Ideally, you would run them for at least a couple of quarters to produce reliable data. Doing so will help meet regulatory and audit expectations to test all models and further document your processes and results. It will also help you minimize the impact and create a budget.
The CECL calculation will likely be higher than your current model. Understanding the discrepancy between the two will help you set aside what you need to inform stakeholders.
Executing a Smooth CECL Transition
You’ll likely need at least a couple of financial quarters for decision-making or solution implementation. A successful implementation includes:
- Collecting historical periods of loss and recovery
- Determining quantitative models
- Assessing pool breakouts
- Calculating the life of loans
- Projecting at least 8-12 quarters forward
- Making qualitative adjustments
Justify all these steps, and you have your CECL solution. That done, you’ll want at least two quarters of parallel runs for CECL testing and validation. So, although 2023 may seem like a while from now, it’ll arrive before you know it. Start sooner, rather than later.
How to Be Proactive for CECL Now
If you haven’t already done so, be proactive now to avoid regulatory, operational or reputational risk. Start by reviewing relevant resources and guidance from auditors. You can also have discussions with regulators.
As you prepare, refer to CSI’s updated CECL Compliance White Paper for a deeper dive into CECL and a step-by-step compliance guide.
Keith Monson serves as CSI’s chief risk officer. In this role, Monson maintains an enterprise-wide compliance framework for risk assessment and reporting, as well as other key components of CSI’s corporate compliance program. With over 30 years of experience, he has a wide range of expertise in the compliance arena, having served as chief compliance officer for both large and small financial institutions.