NEW RULES WILL CHANGE HOW BANKS CALCULATE CREDIT LOSSES
HOW WILL CECL AFFECT YOUR INSTITUTION? THE FINANCIAL ACCOUNTING STANDARDS BOARD’S (FASB) NEW CURRENT EXPECTED CREDIT LOSS (CECL) STANDARD REPRESENTS A SEA-CHANGE TO BANK ACCOUNTING AND POSES SIGNIFICANT OPERATIONAL AND COMPLIANCE CHALLENGES FOR BANKS. INSTITUTIONS WILL EFFECTIVELY BE REQUIRED TO RECORD ALL CREDIT LOSS PROJECTIONS TO OCCUR OVER THE LIFE OF THE LOAN AT THE TIME OF LOAN ORIGINATION OR PURCHASE.
In June 2016, when FASB issued a new accounting standard to calculate credit losses, it ushered in a major shift in the methodology of how financial institutions record impaired loans on their books. Currently, banks mark their loans as healthy up until the point of impairment – that is, only once actual losses have been incurred. The new standard will instead require that institutions use an expected credit loss model, whereby they will be required to calculate expected losses over the life of a loan. Implementation of the CECL model will require a carefully considered strategic plan.
The new standard is the culmination of FASB’s sweeping review of the 2007-2008 financial crisis and its conclusion that it was necessary to revisit how banks estimate losses in the allowance for loan and lease losses (ALLL) calculation. CECL will take effect on a phased-in basis: For fiscal years beginning after December 2019 for Securities and Exchange Commission (SEC) filers, December 2020 for public companies that are not SEC filers and December 2021 for all other organizations.
The transition to the CECL model should not be taken lightly, nor should the amount of time required to plan and prepare for the changeover be under-estimated. To be sure, CECL will bring with it significantly greater data requirements and changes to institutions’ processes, systems and controls to implement the CECL model and accurately account for expected losses. Further, not only will financial institutions need to consider their method for estimating losses, but also the documentation and other support their internal control framework should produce to substantiate their loss estimates. It should be expected that such support will be an area of continued focus by the SEC and other regulators. Since institutions are already well-versed in the concept of incorporating forward-looking information in the preparation of their financial statements, they may have a good starting point from which to develop policies and processes to support the new expected loss estimates.
To best prepare for the new accounting rules, financial institutions are advised to waste no time in commencing early research, data maintenance and communication and strategic planning among members of their management teams. Since implementation is still more than two years away, companies should start by identifying the data they need and, if they don’t already have it, confirm they can collect it. If they don’t have that ability now, banks should make it a priority to make sure they can find a way to get the data and at the same time ensure the appropriate controls are in place around the data. Without question, a big part of planning for CECL will be for institutions to identify gaps where they don’t have the data they will need to perform the accounting required by the standard. Although gathering data may be a challenge, getting a quick start and figuring out what data are needed will help organizations make a smooth transition.
Until the new standard becomes effective, institutions should follow current U.S. GAAP along with the related supervisory guidance on ALLL. One thing to seriously consider is how and when to begin running parallel tests – i.e. maintaining current procedures while at the same time learning and testing the new processes. Institutions will be well-served to allow themselves an adequate period of time to transition to the new standard as the impacts of implementation decisions can be massive. This will allow institutions to rigorously test their new loss allowance models and best practices prior to going live when the time comes.
To prepare for CECL, an implementation framework and playbook should be developed. A well-thought-out integrated approach will lend itself to a consistent framework that is more likely to be accepted by auditors and regulators. A CECL playbook should include detailed roadmaps that describe how initiatives will be implemented and should be thought of as a tactical plan to meet the implementation of the framework’s objectives.
At each financial institution, multiple stakeholders — finance, credit, risk, IT, audit and others — will have a vested interest in planning and implementing the CECL model. Only by working together effectively and clearly defining roles and responsibilities can the stakeholders come together as a cohesive team. The reward for doing so will be turning the challenge of planning for and implementing CECL into an opportunity for improving the financial position and business processes of the institution.