Part 1: How changes to modeling and accounting processes bring change to financial services.
The new Current Expected Credit Loss (CECL) standard could have substantial and far-reaching impacts to the bottom line for many banks, but, outside of the accounting community, many financial services leaders don’t fully understand its implications.
Financial institutions that approach this new challenge as a business opportunity will find that CECL mitigates existing loan accounting headaches, giving them better insight into their portfolio. Done the right way, the strategic implementation of CECL has the potential to become not only a compliance success, but a competitive advantage.
CECL at a Glance
In 2016, the Financial Accounting Standards Board (FASB) released ASU 2016-13, which delivered the final, updated CECL standard. Because it’s an accounting standard, every financial institution, regardless of size, will be required to comply. With an implementation deadline of 2020 for U.S. Securities and Exchange Commission (SEC) filers and 2023 for all other institutions, CECL will completely transform how financial institutions account for portfolio losses by replacing backward-facing incurred loss models used in Allowance for Loan and Lease Losses (ALLL) with a forward-looking lifetime loss calculation. CECL impacts assets measured at amortized costs (loans, held-to-maturity debt securities, leases, etc.), off-balance-sheet items (unused commitments, in certain cases), and available-for-sale debt securities.
Under CECL, banks must now recognize all future expected credit losses over a loan’s life instead of probable “losses in the next 12 months”. This allowance draws on information about past events (e.g., historical credit losses for loans of similar credit risk), current conditions, reasonable and supportable forecasts, and a reversion to historical loss history beyond reasonable and supportable time periods.
For many institutions, CECL may be the first time they must incorporate econometrically sensitive inputs (e.g., economic scenarios for interest rates, unemployment, etc.) into their allowance process. However, because CECL is less descriptive and more principles-based, institutions have flexibility in how they implement the guideline. This could certainly be an advantage to some, but perhaps daunting to others.
CECL vs. Incurred Loss Methods
Before diving more deeply into the CECL guidance, let’s start by taking a look at shortcomings in the existing incurred loss methodology that’s being replaced. After all, the CECL standard conversation began after a thorough examination of the Great Recession revealed some problems with current methodology.
The ALLL process was designed to reserve for probable losses that have already been incurred (embedded losses within a portfolio). But a significant downside of a backward-looking process (which many banks used at the time) is that financial loss reserves during the Great Recession were “too little, too late.” Because banks relied on loss information from the past, a downward-trending economy wasn’t reflected in their allowances. As a result, not only were reserves not available when needed – but they also actually built up post-peak loss reserves as the economy improved, which further reduced liquidity when the market really needed it.
The figure below compares the annualized quarterly net charge-off rate to the ALLL since March 1985 for all commercial banks. The backward-looking nature of the ALLL process is evident as the build-up in allowance coincides with the build-up of actual net charge-offs through the mid-2000s Great Recession period.
Reserve Rate: Federal Reserve Bank of St. Louis and Federal Financial Institutions Examination Council (US), Loan Loss Reserve to Total Loans for all U.S. Banks [USLLRTL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/USLLRTL, September 24, 2020.
NCO Rate: Board of Governors of the Federal Reserve System (US), Charge-Off Rate on All Loans, All Commercial Banks [CORALACBN], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CORALACBN, September 25, 2020.
With CECL and a forward-looking approach, institutions will be better positioned to properly allow for increasing charge-offs ahead of time. Of equal importance, forward-looking components should reduce reserves relative to the incurred loss methodology following recessionary peaks.
While CECL guidance may feel like a complete overhaul to the incurred loss approach, both methodologies rely on past events and historical experience, with CECL adding a forward-looking component. In place of the loss emergence period used in the earlier methodology comes the R&S period (i.e., a period in which reliable forward-looking forecasts can be used) and a reversion to historical loss rates after that. While this reversion is not prescribed and remains open to various approaches, institutions might link historical loss information to their current ALLL analytics.
The figure below demonstrates how an 18-month forecast might look for a given pool of loans. The first eight months represent an economically sensitive R&S period, followed by a reversion to historical rates over a four-month time period, and then a reliance on historical rates thereafter.
To Be Continued
While CECL’s more forward-looking framework provides greater clarity on expected loss, it’s not without its implementation challenges. In Part 2 of our CECL series, we explore several areas where banks can find the hidden opportunity.