Federal regulators are barely two years away from transitioning to a radical new accounting standard that poses a significant issue for the banking industry, and, whatever its intent, is viewed by many as another rule that will make consultants rich, confuse investors and risk managers, and ultimately require significant implementation investments from banks.
The final rule – which was unveiled last year following a long and contentious battle between representatives of the banking industry and numerous governmental agencies – will replace the legacy Allowance for Loan and Lease Losses (ALLL), or “incurred loss” model of bank accounting with the far more complex Current Expected Credit Loss (CECL) standard established by the Financial Accounting Standards Board (FASB).
The goal of both approaches is to give those reading a lender’s financial statements a fair picture of the economics of making loans by including expectations for losses. Both models rely on a lender’s historical loss data, and provide an estimate of future losses based on certain assumptions and a given timeframe. Under FASB’s new rules – which are scheduled to begin taking effect in 2020 – banks will be required to record expenses and book reserves upfront for expected losses for the life of each loan based on loan-risk characteristics, and a “reasonably supportable” macroeconomic projection of the future.
One of the more controversial aspects of CECL is the introduction of this new “life-of-loan” concept that will require lenders to calculate the probability of default for the duration of a loan’s term. Compare that to the existing “loss emergence period” (LEP) standard, which can vary considerably depending on the product type and workout periods, but for most commercial loans involves forecasting losses over a 12-18 month period.
Bank regulators have described CECL as the “biggest change to bank accounting ever.”
Naturally, the process has generated a strong backlash from the community banking sector, which has expressed significant concerns about small banks’ ability to comply with CECL.
“To perform the CECL calculations a community banker needs data, lots of data,” wrote Peter Cherpack, Executive Vice President at Ardmore Banking Advisors, Inc., in a white paper explaining the impact of CECL on smaller institutions. “They will need data on their loans, data on their borrowers, and data on the performance of the regional and national economy.”
Jack Hartings, former Chairman of the Independent Community Bankers of America (ICBA), equated the task with developing the banking equivalent of a “crystal ball,” and warned this added burden could cost “thousands of jobs and financing options that keep small communities thriving.”
While the impact of CECL on reserve levels will vary from bank to bank based on the loan mix within each individual bank’s portfolio and differing capital provisioning policies, some experts warn it could result in a significant rise in capital reserve requirements for some banks. It is certain, though, that the new approach will impose higher costs and compliance burdens on every bank, adding to the load that challenges the success of community banking.
In response to these concerns, in April 2016 FASB held the first meeting of its Transition Resource Group (TRG) – a roundtable of experts that included representatives of community banks and credit unions. Two months later the group issued a revised guidance that eased some of the requirements for community and regional banks.
For instance, many of the loss-estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. The revised CECL proposal also includes added flexibility for community banks, which will allow them to apply a “personal understanding” of their local markets rather than complex modeling systems to determine their loan-loss reserves.
Representatives of the banking community have expressed muted optimism about the modifications.
“While we continue to have strong concerns with the costs related to CECL’s life-of-loan loss concept, we are committed to working with both regulators and auditors to ensure banks of all sizes can meet the implementation challenges of the new standard,” said Rob Nichols, President and CEO of the American Bankers Association.
But even with the looser requirements, data suggests few banks are prepared to make the leap to CECL – which is fast approaching.
In October, a survey from financial technology provider SS&C Technologies Holdings revealed a marked decline in banks’ confidence in their ability to address the standard via existing reserving processes. The survey identified several stress points for community banks – with top concerns around the accuracy and integrity of data; the ability to identify the appropriate data elements; and their ability to manage the large quantities of data required to meet the new forecasting standards.
Another study found that fewer than half of banks have even selected the methodologies they will use to implement CECL.
CECL will have a wide-ranging impact on financial institutions’ allowance processes; experts recommend getting a head start on developing that holistic approach and recommend that you:
- Think: about models and which one will best fit your bank;
- Consider: what data you’ll need to fulfill that model and begin compiling sources; and,
- Collaborate: CECL implementation is not a one person job. Create a transition team that includes accounting, operations, lending, and IT personnel.