Ready Or Not, Here Comes CECL

Growing up in the country, playing hide and seek under the cover of darkness was great fun! With a barn and other out-buildings to provide hiding spots and acres of orchards and yard to roam, it was tailor-made for the person hiding. For the “seeker,” not so much. Unlike childhood games that are optional and generally fun, new Current Expected Credit Loss (CECL) regulations are here. They are mandatory and the clock is running.

Ready Or Not, Here Comes CECL

In June 2016, the Financial Accounting Standards Board (FASB) published Accounting Standards Update (ASU) on Financial Investments – Credit Losses (Topic 326). In July 2019, the OCC, FDIC, Federal Reserve, and the NCUA published the Interagency Policy Statement on Allowance for Credit Losses with detailed implementation guidance. This interagency guidance affects all entities holding loans, debt securities, trade receivables, and off-balance sheet credit exposure and promises to be the most significant accounting project for financial institutions for the next five years.

Like it or not, Ready Or Not, Here Comes CECL. At its core, it is a fundamental change in Accounting for Credit Losses (ACL). Historically, institutions used an incurred-losses approach. This looks at historical loss experience adjusted for current conditions to project probable credit losses over the next 12 months. CECL rules are more “forward looking” by removing the probable loss threshold and requires a lifetime credit loss allowance be established on day one for each exposure. This change not only impacts how your financial institution calculates the loss reserve but how the organization will manage their Allowance for Loan and Lease Losses (ALLL) and the internal process for both finance and risk management. The overall changes set forth in CECL guidance will require a much deeper level of loss modeling, analysis, and reporting.

Approaches for Loss Analysis

The Interagency Guidance and FASB Topic 326 provide (broadly speaking) for two approaches to loss analysis: collective or pool, and individual. On a collective basis, the institution may choose to group assets by such common characteristics. These include similar risk rating or classification, collateral type, tenor, geography, industry, etc. Alternatively, if a particular exposure does not fit into a particular asset pool, it may be analyzed on an individual basis. The institution may not use both approaches for the same asset. But it is not required to apply one approach to all assets. Further, the institution is not required to keep a specific asset in a particular category over time. Loss calculations will need to be updated with each reporting period or Most Recent Quarter (MRQ).

Implementation of these new accounting rules began for publicly traded institutions (SEC filers) for fiscal years beginning after 12/15/2019. According to recent studies and articles, initial filers have reported higher loss reserve levels. Given that increased credit loss provisions represent such a significant impact to the income statement, and with the increased likelihood of negative economic impacts coming due to inflation, interest rate hikes, and business slowdowns, implementation is likely to add additional stress to a lending institution’s earnings and balance sheet.

How To Begin?

Ready Or Not, Here Comes CECL! FASB Topic 326 is effective for all remaining entities with fiscal years’ beginning after December 15, 2022. For those institutions that have not begun the process of transitioning to the new CECL process, it would be prudent to begin soon. A good place to start would be with a detailed analysis of historical charge-off reports. Are there common elements that may be attributed to the charged-off loans such as loan type, collateral, industry, term, etc. Are there any common trends or themes? Common risk characteristics such as loan-to-value, initial cash flow coverage, risk rating? From this analysis can you determine a “lifetime loss rate” for a particular asset pool?

Methodology

Once data is compiled and analysis completed, an appropriate methodology for ongoing analysis can be selected and evaluated. CECL does provide flexibility to adjust any historical loss calculation for current conditions. Also, use of “reasonable and supportable” forecasts of future conditions. These qualitative adjustments can be made based upon macro considerations. These would include the overall economic performance, as well as on micro level considerations such as closure of a local factory or major community employer.

A couple of things are clear from these new regulations. First, they will involve a substantial amount of time, effort, analysis, and testing to develop. Second, implementation will have a significant impact on both the institutions earnings and capital.

So, although there is nowhere to “hide” from the need to implement the new CECL requirements in accordance with FASB standards and Interagency Guidance, there is an option to seek. Enlighten Financial can review your CECL-adjusted ACL methodology. We provide recommendations for adjustments where appropriate including documentation of revised policies and procedures. Or, as it is said, seek and you shall find. Ready Or Not, Here Comes CECL!

Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape. We lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.445.8133.