A recent poll asked financial services leaders when their organizations expect to execute preliminary current expected credit loss (CECL) calculations for the allowance for loan and lease losses (ALLL). And their statements on the future have direct implications on the present.
Forty-two percent of respondents said institutions should execute calculations by the fourth quarter of 2017. Another twenty-four percent said institutions should wait until after 2017. The difference in opinion likely stems from different levels of preparedness today and implementation timeframes established by the Financial Accounting Standards Board (FASB). But the data does suggest that institutions intend to run a preliminary CECL calculation well in advance of implementation deadlines.
As suggested by the data, institutions should be in the planning phase for the accounting change—now. Preliminary CECL calculations help bankers determine how the standard may affect their institution, and to understand the potential resources required. Here we’ll examine two important planning steps: creating an implementation committee and defining a project plan.
The importance of implementation committees
Formed under the direction of either senior management or the board of directors, the implementation committee should likely include senior staff from several departments—including finance, credit, risk management, IT and audit. These committee members may not realize today how the ALLL affects their department. But they will play a critical role in executing a CECL calculation and may be impacted by its requirements.
Once the committee is formed, establish group objectives and key milestones to inform the more intermediary steps of the implementation project plan. For most institutions, the committee must also assign responsibilities or name parties accountable for the plan’s different pieces. So early on, the committee can create the short list of human resource requirements.
The crucial span of the project plan
The first step in the project plan involves the evaluation of the current ALLL methodology and the processes used to estimate the reserve today. The evaluation should consider:
- Data gathering processes
- The platform used to perform the calculation
- Who the responsible parties are
- Turnaround times and workflow for the process, and
- Expectations for reporting
This exercise may uncover additional parties who must be represented in the committee or additional resources to help execute the preliminary CECL calculation. It may also unearth opportunities to improve ALLL processes and implement data integrity and stress testing programs that benefit the institution’s risk management framework.
There are four major categories to consider with the implementation project plan:
1. Methodology changes
Moving from the incurred loss model to lifetime expected losses under CECL marks a fundamental change in how institutions estimate their ALLL. At a minimum, this change requires different inputs into existing models and may encourage some institutions to evaluate more sophisticated methodologies. As the FASB’s 2016 CECL standard is not prescriptive regarding which methodologies to employ and how to use them, each institution must individually evaluate the different options and document which methodologies best fit their loan portfolio and why. It will be essential to evaluate these methodology choices over time to compare their sensitivities to changes in market conditions and the loan portfolio. As institutions hone in on their final model, they will also need to allow time for model validation and the development of appropriate internal controls.
2. Data requirements
Access to high-quality historical data on the loan portfolio will be critical for the transition to CECL, since many methodologies require granular, loan-level details. Ideally, institutions will capture snapshots of the loan portfolio on a monthly or quarterly basis with loan-level characteristics. As the primary goal of the CECL standard is to reserve for lifetime losses, this data will help determine key, model inputs.
There is no “minimum” amount required for CECL, but the longer the data set, the better the institution’s ability to employ lifetime analytics and models. Ideally, the time series would span a full business cycle—including recessions and expansions—but that challenge most institutions that lacked a data archiving system in place prior to CECL.
Limited amounts of historical data may restrict the methodology options available to the institution. So now marks the ideal time to ensure the capture of granular data.
3. Capital adjustment
The CECL model will likely require a one-time adjustment to capital to account for changes in the allowance level. Capital can prove difficult and/or expensive to raise, so institutions will need to forecast the magnitude of any possible adjustment to determine as soon as possible whether raising additional capital is necessary.
4. Projected impact
CECL may effect the institution in many ways, and many industry experts believe the new standard may lead to higher reserves and potential fluctuations in provision expenses. Because provision affects net income, earnings projections may be impacted. Conversely, in some cases CECL may reduce ALLL levels. Institutions may also find that their peer comparisons may change due to unique applications of the non-prescriptive model across different portfolios.
CECL’s goal is to help institutions proactively identify, mitigate and reserve for risk in their portfolios. Much of the data CECL requires can be leveraged in stress tests, too, making these exercises easier to adopt. As a result of enhanced ALLL and expanded stress testing, institutions will gain a more complete picture of credit risk and steps needed to bolster safety and soundness.
It may sound tempting enough in a world of consumer demands, FinTech disruptions and emergent distractions to put CECL implementations off to the side. But to delay the essential planning won’t take away from the urgency or complexity this accounting exercise demands. BY all CECL calculations, the time to act begins once you end this sentence.
Tim McPeak is an executive risk management consultant with Raleigh, N.C.-based Sageworks. He can be reached at firstname.lastname@example.org.