The Current Expected Credit Loss accounting standard (CECL) takes effect for financial institutions as early as next year, though palpable foot-dragging has accompanied the ramp up. And no wonder: Many view it as a regulatory burden as thorny as its tongue-twisting title. As one of the biggest changes to bank accounting in generations, CECL will require institutions to calculate the expected loss over the life of each loan—and set aside reserves at the time of origination to cover those losses.
Given the cyclical nature of lending and the unpredictable economy, this could present a major challenge. A primary concern involves how this rule will impact earnings and net income. Some project that this will force the industry to hike its reserve levels to $246 billion, equal to 1.5 times the amount under the current model—a significant increase.
Yet CECL also offers an opportunity for financial institutions to remain more competitive—regardless of the economic environment. As BAI managing director Karl Dahlgren recently noted, “It’s clear banks have to make an ongoing investment in compliance that not only satisfies regulators, but also gives banks a competitive advantage. Compliance is too often looked at as a necessary evil. Smart banks know that an organization-wide commitment to compliance delivers financial rewards."
How data shrinks risk and grows profits
To adhere to CECL, financial institutions need to adjust its loss allowance when the credit quality of its portfolio changes. This can prove difficult, especially given varying economic factors. But it can also minimize risk.
On the surface, this may appear to impact an institution’s income. But long term, CECL will allow institutions to predict loss allowances more accurately—provided they possess sufficient data. With data analytics capabilities, institutions can more accurately see future economic conditions prone to impact portfolio performance. In turn, they can make changes that minimize risk and protect their income.
To achieve this, financial services organizations must prepare their data now. Any data gaps or issues related to accuracy and accessibility will not only impact CECL compliance but also risk and profitability. By building out this data early on, banks will adhere to the standard and gain a clearer, invaluable view of risk.
The start of improved loan origination
CECL will also require financial institutions to look closely at the loan origination process. By identifying areas to improve and optimize the consistency and efficiency of originations, they will gain a more accurate perspective as to how changes in risk exposure will influence a loan’s performance.
Underwriters need access to relevant data to evaluate loan applicants. This in turn clarifies an understanding of which loans drive profitability—or hinder it. That allows lenders to more effectively segment loans into pools, from which deeper insights emerge as to how each performs and what influences its performance.
Discerning differences in portfolio performance
As institutions capture credit quality indicators at the time of origination and throughout the loan’s life, financial institutions will track how different portfolios perform over time and through different economic scenarios. This creates a crystal-clear snapshot of which economic factors impact specific portfolios. Changes in a portfolio’s credit quality can be cross analyzed with external data that includes interest rates, unemployment rates and housing values, among other national or regional metrics.
Because each financial institution enjoys a unique customer base and portfolio makeup, loan portfolios will perform differently. Two financial institutions in the same city might each have a book of auto loans—but when interest rates rise, perhaps just one feels the impact simply because rising rates influence their borrowers.
Moreover, for certain types of loans, certain credit quality indicators can better predict performance. For example, a bank might find that an overdrawn account is an accurate indicator of a potential credit loss on a personal loan, while no deposit activity in 60 days is the most relevant one for a business loan.
Final thoughts: Data leads the way and wins the day
CECL will clearly change how financial institutions lend. Many of the widespread effects will not appear for several years, but this much we can conclude: The richness and types of data used to decision and monitor loans will become critical. Not only will it help financial institutions adhere to CECL guidelines but also create a competitive advantage.
Moving beyond compliance to address the true intent of CECL—to better manage risk—ultimately supports improved underwriting, loan pricing and targeting for marketing campaigns. And as it also enhances portfolio profitability, CECL will truly extend timely support that’s worth lending.
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John M. Deignan is president and CEO at Baker Hill.