The new Financial Accounting Standards Board (FASB) rule for estimating expected credit losses has been dubbed the most significant change in the history of bank accounting. In addition to changing the way they calculate credit losses, most banks and financial services companies (insurance companies, finance companies, and credit unions) will need to make significant process changes in the way they collect data and adapt their existing technology, financial models and governance structures to comply with the new standard.
The current expected credit loss (CECL) standard removes the existing “probable” threshold for loss recognition and requires banks to calculate credit losses using a more forward-looking approach to encompass lifetime expected losses. Determining the lifetime of a financial asset could prove challenging as banks factor expected prepayments (or anticipated troubled debt restructurings) in to the estimate.
More Than an Accounting Issue
The impact of the new standard extends far beyond accounting and financial reporting. The credit management function is directly affected as banks must continue to actively monitor, analyze and manage their portfolios in a way that improves income and maximizes capital efficiency, even as they adapt their allowance calculation policies and processes to accommodate the new standard.
Credit risk management programs will need to be even more proactive in identifying developing trends in portfolios by way of frequent risk assessment and re-evaluation of risk appetite. This heightened activity could have an impact on recommendations for certain newer credits, terms and structures adopted and on the analysis of different metrics for CECL forecasting purposes. Banks also must reassess their model risk management approaches and implement new processes that address the changes to adopt a CECL model.
Above all, adopting a CECL model to comply with the new standard might require much more data gathering than was required for previous credit loss calculation methods. Banks might have to consider the need to redefine their data management requirements to include more robust portfolio data, borrower and economic data, exposure-level data, historical balances, risk ratings, charge-off and recovery data, and appropriate peer and industry data.
Although no simple solutions exist, it is possible to outline a comprehensive program to assess the challenges and begin planning for the changes over the next few years. At the highest level, such a program would be composed of the following components:
Risk identification: Understand portfolio characteristics and drivers of portfolio performance, including lending attributes, loan structures, prepayment risks, and changes in the macroeconomic environment. This component will enable a bank to appropriately segment and model its portfolios based on common drivers of risk.
Governance and oversight: Understand risk management practices surrounding the development, execution, and maintenance of the CECL model. This includes established roles and responsibilities of the board and senior management, as well as policies and procedures in place to articulate the expectations of the CECL model and ongoing execution of the model.
Enabling technology: Understand the existing systems, including the capabilities and limitations of those systems that might support the execution of the CECL model. This includes source systems, data warehouses, modeling systems, financial statement spreading software, and vendor technology specially designed for CECL.
Accounting and regulatory alignment: Assess the ability of the CECL model to meet accounting and regulatory needs and objectives.
Data inventory: Understand the availability and limitations of data required to develop and maintain an effective CECL model. This includes the reliability and accuracy of data elements in addition to the historical time horizon of data availability.
Resource capabilities: Understand the capabilities and limitations of the human resources identified to develop and execute on the CECL model.
Most banks and financial services companies face a challenging road ahead. Outlining a comprehensive and achievable approach to adapt to these extensive changes is a positive first step to successfully transition to the new CECL model.