Historically, banks have based credit loss reserves on the amount of loan losses they’ve incurred in the past. However, this will soon be changing—and this change will represent one of the biggest shifts banks have faced in decades.
The change is a result of the Current Expected Credit Loss (CECL) standard issued two years ago by the FASB. The new CECL standard will require banks to calculate reserves based on expected future losses rather than on incurred past losses. It’s estimated that banks’ Allowance for Loan and Lease Losses (ALLL) could increase by up to 50% or more under CECL.
Some CECL Background
CECL was adopted largely in response to the financial crisis of 2008–2009. Between 2004 and 2007, loan loss reserves at FDIC-insured lending institutions shrank by 10 percent while loan volumes soared by 44 percent. Incurred loss accounting “was not in step with the significant expansion of credit risk leading up to the crisis,” said FASB Chairman Russell Goldman.
CECL is intended to correct this mismatch by mandating improvements in accounting for credit losses. It will require lending institutions to capture, analyze, interpret, and store more data as they assess potential losses whenever putting financial assets on their books instead of setting aside reserves only when losses appear probable.
Specifically, you will need to create a lifetime expected loss estimate model that considers historical experience, current conditions, and reasonable and supportable forecasts. In essence, you’ll have to estimate future loan losses for the life of every loan you make.
Banks that file with the SEC must comply with CECL after December 15, 2019, while other banks have an additional year to comply. This might sound like it’s a long way off, but given the complexity of implementing programs to comply with CECL, it’s not too early to start the planning process now.
Here are 5 steps to get you on the road to CECL implementation:
- Form an implementation team. Preparing for CECL compliance is a massive data-driven exercise, so the more hands on deck, the better. By including stakeholders from across the organization, you’ll get unique perspectives and understandings on the implementation challenge.
- Determine your data requirements. This will likely be the hardest and most time-consuming aspect of the process. Start by organizing loans according to different types—C&I, CRE, ADC, etc.—and then pool loans to more refined levels to see which types of loans share similar risk characteristics.
- Decide on a methodology for projecting credit losses. You will be allowed to continue using your existing methodology under CECL, whether this is a loss method, migration or vintage analysis, discounted cash flows, or probability of default and loss given default. You might decide to use a different methodology for CECL. In any case, your method will need to be modified in accordance with the new CECL standard.
- Identify a technology partner. You may need help from a third-party source in order to handle the data collection and analysis tasks required for CECL compliance. Look for a technology partner that provides a comprehensive and proven solution—from risk management to profitability analytics—that’s both simple and scalable.
- Adjust your reserve. Once you’ve made a reasonable and supportable assumption about the anticipated direction of loan losses, you’ll need to make a one-time adjustment to your loan loss reserve upon CECL adoption. You can revise your forecasts and loss estimates over time as conditions evolve and you capture more data.
It’s More Than Just Compliance
While it’s easy to view CECL strictly as a compliance issue, your bank can reap numerous benefits from your investment in CECL implementation. These include more accurate budgeting and forecasting, better risk analysis and strategic planning, and improved profitability.
Please contact us if you have more questions about preparing for CECL compliance and implementation 417-881-0145.