After years of waiting and debating, the long awaited credit losses standard has finally been issued. The pronouncement introduces the idea of a new "Current Expected Credit Losses" model (affectionately known as "CECL"). CECL will impact the accounting and reporting related to financial assets reported at amortized cost (primarily loans and trades receivable) as well as debt securities and off-balance sheet credit exposure. However, the scope of this article is geared almost exclusively towards financial institutions and how the new standards relate to the allowance for loan losses.
At a high level, the concept is fairly simple. Previously financial institutions were recording an allowance for loan losses based on losses which were currently incurred. In other words, what do I have for losses in my portfolio right now? The new requirement is to estimate all expected credit losses throughout the life of the portfolio. Said another way, we now not only have to worry about today's problems, we also have to worry about tomorrow's.
So What Does CECL Mean?
There are several specific tenets which need to be followed with the new model:
- Expected losses should be estimated over the contractual term with consideration given to prepayments but not to expected extensions or modifications.
- Expected losses should be measured on a pool basis whenever similar risk characteristics exist.
- You cannot rely solely on past events. Historical loss information must be adjusted based on current conditions with "reasonable and supportable forecasts."
- When estimating expected losses for periods where reasonable and supportable forecasts are not possible, revert to historical losses.
- Some expected losses should be recorded even when risk of loss is remote.
- Loans which do not share risk characteristics with other loans will need to be evaluated individually.
So now we have a set of rules which we should be following, but exactly what does that mean and how are we going to develop an allowance calculation which incorporates these tenets? Well, the standards essentially say you need to use a reasonable approach and give a few examples but pointedly don't prescribe any one method which is preferable over another. Each method requires different inputs, assumptions, pros and cons. What follows is a very brief description of several methods which may be acceptable models under CECL:
Discounted Cash Flow – This method is a projection of future principal and interest payments discounted at the loan's effective interest rate. It should be noted that most readers will be familiar with this approach as the concept is also an integral part of the current standards. This method is one acceptable approach for loans which need to be evaluated individually as their risk characteristics are not common to other loan pools.
Loss Rate Approach – This method calculates a historical lifetime loss rate for loans with similar risk characteristics. Said another way, when I originate a residential real estate loan, I expect losses of .8% by the time it is fully paid off. This loss rate is then adjusted for current conditions and reasonable and supportable forecasts.
Vintage Year – In this method, loss rates are developed by vintage year and tracked by year through maturity. This historical information is then adjusted for current conditions and reasonable and supportable forecasts to project losses on the current loan portfolio. Similar to the loss rate approach, this method attempts to capture losses over the history of a loan but in theory can be more accurate in that it can specifically identify when in a loan's life the losses are expected to occur.
Probability of Default – This method calculates the expected number of borrowers who will default over time and multiplies that result by the estimated losses to the bank when a borrower defaults.
Migration Analysis – In this method, the financial institution tracks the movement of loans through loan classifications to determine the probable losses to be incurred on similar loans in the portfolio.
Practical Expedient – Loans which are collateral dependent (repayment is expected primarily from the sale or operation of the underlying collateral) may use the fair value less cost to sell to calculate expected credit losses.
So What's the Plan?
Now that we know what the rules are and a few of the approaches that would be acceptable, the obvious question is: what now?
Establish a Team – Before anyone even starts to dig into the details, a decision needs to be made as to who is going to be doing the digging. The list of who should be involved might be longer than you think. The reason for this is more fully described in step one. We would recommend at a minimum your task force include someone from senior management, accounting, loan operations, and information technology. It is also highly likely that resources at your loan accounting vendors will need to be included at some point in the process as well.
Research - The first step is going to be research. Regardless of the method eventually adopted, the fact is that more information is going to be required going forward. Depending on the approach, this information could include dividing loans into pools with similar risk characteristics, prepayment rates, annual loss rates by vintage year, loan migration information, default rates, etc. Some of this information is going to be easy to obtain and some of it is going to require a lot more work, including coordination with vendors.
Planning/Testing - The second step is to start planning and testing whichever method, or combination of methods, you choose to employ. This involves gathering all the information (hopefully you actually have access to everything you believe you do). You also need to decide whether you are going to develop a system in-house or use third party generated products. Thankfully, regulators (see FIL 39-2016) have indicated that their intent is to reasonably apply the standards based on the size and complexity of the various institutions. They have also specifically indicated that in many instances, institutions will be able to leverage and adapt the systems they currently use.
CECL is also going to require significant amounts of testing. Once you have a model that you like, does it actually work like you think it should? In other words, when you actually perform the calculation, are you getting reasonable results?
Monitor – At this point CECL is a very fluid concept, as no one has actually seen the concepts adapted into practice. General industry belief is that as time goes by there will be additional guidance available from regulatory bodies. Additionally, community banks will be able to monitor the practices adopted by SEC filers who will have to adopt a year early. A prudent approach will be to do as much work as you can as early as you can, but remain flexible as new guidance is available.
Implement – Early adoption is allowed in 2019 – any takers?
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.