Four letters—CECL—may signify one of the most profound revolutions in financial services since FDIC.
The financial services industry is heralding the current expected credit loss standard (CECL) as “the biggest accounting change in banking history.” As the Financial Accounting Standards Board’s (FASB) Accounting Standard Update, CECL will affect all lenders and fundamentally change how institutions account for expected credit losses.
Under the current incurred-loss model, banks use relatively simple analytical models to recognize credit losses when they had reached a probable threshold of loss. Many analysts have suggested that this vastly underrepresents potential losses in an economic downturn.
Now, when CECL takes effect in 2020, banks will be required to calculate expected loss over the life of each loan and recognize the expected loss upon origination. Compliance will demand producing supportable forecasts, conditioned on the current environment, using more sophisticated models and more detailed historical data. For banks and financial services institutions, preparation can make the transition smooth—though by no means automatic.
Financial teams have addressing myriad issues involved in CECL implementation since FASB introduced the standard in 2016. Until now, they have primarily focused on interpreting it and developing lifetime loss models. But it is also critical to focus on more fundamental issues: Namely, how can finance teams create sustainable processes for allowance and loan lease losses (ALLL), and for finance and risk management? Firms must ensure implementation of the strong governance and controls necessary to meet regulators’ and auditors’ expectations as they efficiently meet the ongoing demands of financial reporting.
By proactively implementing a CECL process that is controlled, efficient, collaborative and sustainable, financial firms also achieve numerous long-term advantages, such as:
fewer resources for regular ALLL production
faster responses to inquiries from management, auditors and regulators
less opportunities for audit/regulatory findings
lower key person risks
more flexibility to adapt to maturing interpretations of the standard and evolving best practices
reduced maintenance costs, and
better collaboration between development, validation and production teams.
Given the scope of changes under the new accounting standard, banks have found it difficult to meet the challenges of governance and controls. In 2016, the Global Public Policy Committee (GPPC), a consortium of six of the largest accounting agencies, issued a joint white paper to help with this process. Though intended to assist audit committees in implementing the international IFRS 9 standard, published by the International Accounting Standards Board in 2014, the paper also helps firms comprehend auditor demands for CECL.
The GPPC paper recommends that institutions establish an effective governance and control framework that controls data, methodologies, models, systems and processes before, during and after the transition:
Data. While firms may use data to address the current allowance, the greater complexity of the new models will require additional data from both internal and third-party sources. Since this data may be housed across different systems—with different data definitions and varying levels of detail—experts must be on hand to cleanse, align and augment. Banks also need to give reviewers evidence that they’ve properly vetted the data and that it is fit for purpose. Banks should develop plans to address any shortcomings with their existing data and demonstrate continuous progress toward a resolution.
Methodologies. For a sustainable approach to CECL, institutions need an integrated, holistic strategy that incorporates people, processes and systems. Make sure methodologies become transparent and well documented, and consistency across the organization should be understood. Decisions around methods and assumptions should be well supported and governed.
Models. Firms will need to determine to what extent they’ll use existing models or develop new ones. They must validate models, and the validation status demands monitoring. Even previously validated models will need reevaluation if used for purposes outside their original intent.
Systems and processes. Governance over the entire process—including all aspects of data, models, integration and reporting—is critical to a successful outcome. Systems and processes should be substantially automated (with appropriate quality assurance controls in place) to meet the timing demands of financial reporting. Because the portfolio, credit environment and interpretation of CECL standards will vary over time, systems should adapt as they support existing requirements.
A successful CECL implementation begins with the basics. Developing appropriate models isn’t enough. Firms must meet the expectations of regulators and auditors in an efficient, sustainable manner. By using CECL as a catalyst to centralize and enhance processes, firms can improve long-term productivity, increase analytical reuse, and deliver long-term value.
Let those four initials, then, initial the start of something powerful and positive for your organization.
John Voigt is a Risk Solutions Manager at SAS. Through this work, he has developed practical domain knowledge across critical financial areas, including Basel II/III, stress testing, economic capital, credit loss forecasting and loss reserving.
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