In December 2012, the Financial Accounting Standard Board (FASB) proposed a new current expected credit loss (CECL) model. With it came a number of changes and controversy, as institutions recognized the potential of an increase in allowance levels as a result of the changes to how losses are estimated.
While many institutions, associations and firms submitted comment letters to provide feedback to the FASB on the model, it is ultimately left in the Board’s hands to determine the final accounting standard. While that is still under discussion, the FASB expects to release the final CECL guidance in the first quarter of 2016. Despite the uncertainty, there are a number of steps institutions can take now to prepare for the proposed changes:
Don’t panic! With the proposed move to an expected loss model garnering industry “buzz,” it would be understandable for senior management at a bank to feel a sense of panic as they try to anticipate the finalized guidance and how their institution will comply. Instead, institutions would be better served by understanding what the changes mean, monitoring industry news and interpretations of the topic, and examining internal data-gathering processes.
Improve data collection. One thing from the new guidance is certain: institutions will need more robust data on their loan portfolios, borrowers and external economic factors to make supportable estimates of credit losses going forward. And, institutions can begin gathering that data now to ensure access to the right data and to establish processes to collect information on an ongoing basis.
Specifically, if it isn’t already being captured, loan-level data like historical balances, risk ratings, charge-offs and recoveries should be collected. Additionally, other data that could be correlated to loan losses should be collected as well. Examples include national, regional and local economic data, borrower financial data and real estate metrics, such as price indices. At this stage, it is likely better to err on the side of too much information, as it may prevent hunting down historical data in the future.
As the new model considers the life of a loan in the portfolio, as well as booking a lifetime loss, it is likely that financial institutions will have to determine and document, by a historical and data-driven analysis, the average life of a loan in a segment of the portfolio along with the expected loss. The more portfolio data collected, the more precisely institutions can calculate expected losses. With more data, the more likely institutions will be able to defend the calculation to examiners and auditors.
Start cross-department conversation. Most likely, there will be more sharing of information and collaboration within your institution under CECL. A good step now is to determine who in the institution will be designated the keeper of the aforementioned data and how that information will be made accessible to the parties involved in the Allowance for Loan and Lease Losses (ALLL) under CECL, likely Credit and Finance. Also, continue researching the ongoing CECL conversation and start developing your institution’s plan and timeframe.
Strengthen risk rating procedures at the institution. An effective risk rating system goes beyond determining a credit approval process or loan pricing. These systems impact broader risk management practices, such as setting an institution’s reserve, stress testing and strategic planning. The CECL model will require more granular calculations, and methodologies that have been discussed as part of CECL, such as migration analysis, probability of default/loss given default, vintage analysis and cohort analysis, will rely more heavily on accurate, timely risk ratings.
The OCC’s Survey of Credit Underwriting Practices explained that examiners expect the level of credit risk to increase over the next year in not only commercial loan portfolios, but retail loan portfolios as well. Consequently, moving forward, the importance and effectiveness of risk rating systems are likely to be emphasized by examiners.
Capital planning. Many analysts believe that the CECL model will increase an institution’s allowance reserve, requiring a one-time capital adjustment. In order to plan for this adjustment, institutions should take advantage of the time between now and their implementation date to run scenarios, test different methodologies and analyze what impact the new model may have on the calculation. Institutions that take proactive steps to understand the potential impact on the reserve calculation can plan in advance to ensure they can adequately cover the capital needed for the adjustment.
Develop a set of talking points. As the “buzz” around CECL gets louder, senior management, board members and other stakeholders may start to pressure the staff responsible for the ALLL by asking for a plan of action and expected results. Since a detailed plan to comply would be premature until the new standards are finalized, it may be helpful to instead establish a set of talking points to proactively address these questions from stakeholders. These points should address not only what we currently know about the proposal, but also what remains to be clarified.
Utilize available resources. Keeping an open dialogue with examiners, auditors and other external consultants and vendors on the proposed changes will be critical to understanding the eventual compliance requirements and the impact on reserve levels. These professionals likely have some familiarity with the institution and can therefore act as a sounding board or advisor as the proposal is modified and eventually finalized.
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