Executives gearing up for the transition to the new loan loss accounting standard need to understand their methodologies and be prepared to explain them.
Many banks are well underway in their transition to the current expected credit loss methodology, or CECL, and coming up with a preliminary allowance estimate under the new standard. CECL will require banks to book their allowance based on expected credit losses for the life of their assets, rather than when the loss has been incurred.
The standard goes into effect for some institutions in 2020, which is slightly more than six months away. To prepare, executives are reviewing their bank’s initial CECL allowance, beginning to operationalize their process and preparing the documentation around their decision-making and approach. As they do this, they will need to keep in mind the following key considerations:
Bankers will need time to review their bank’s preliminary results and make adjustments as appropriate. Banks may be surprised by their initial allowance adjustments under CECL. Some banks with shorter-term portfolios have disclosed that they expect a decrease of their allowance under CECL, compared to the incurred loss estimate.
Some firms may find that they do not have the data needed to segment assets at the level they initially intended or to use certain loan loss methodologies. These findings will require a bank to spend more time evaluating different options, such as identifying simpler methodologies or switching to a segmentation approach that is less granular.
These preliminary CECL results may take longer to analyze and understand. Executives will need to understand how the assumptions the bank made influence the allowance. These assumptions include the periods from which the bank gathered its historical loss information for each segment, the reasonable and supportable forecast period, the reversion period, its prepayment assumptions, the contractual life of its loans—and how these interact. Bankers need to leave enough time for their institutions to iterate through this process and become comfortable with their results.
Incorporate less material or non-mainline loan asset classes into the overall process. Many banks spent last year determining and analyzing various loan loss methodologies and how those approaches would potentially impact their larger and more material asset classes. They should now broaden their focus to include less material or non-mainline asset classes as well.
Banks may be able to use a simplified methodology for these assets, but they will still need to be integrated into the bank’s core CECL process to satisfy internal controls and management and financial reporting.
Own the model and calculations. Executives will need to support their methodology elections and model calculations. This means they will need to explain the data and detailed calculations they used to develop their bank’s CECL estimate. It includes documenting why they decided that certain models or methodologies were the most appropriate for their institution and for specific portfolios, how they came to agree upon their key assumptions and what internal processes they use to validate and monitor their model’s performance.
Auditors and regulators expect the same level of scrutiny from executives whether the bank uses an internally developed model, engages with a vendor or purchases peer data. Executives may need specialized resources or additional internal governance and oversight to aid this process.
Know the qualitative adjustments. Qualitative adjustments may shift in the transition from an incurred loss approach to an expected lifetime one. Executives will need a deep understanding of the bank’s portfolios and how their concentration of risk has changed over time. They will also need to have an in-depth knowledge of the models and calculations their bank uses to determine the CECL allowance, so they can understand which credit characteristics and macro-economic variables are contemplated in the models. This knowledge will inform the need for additional qualitative adjustments.
Anticipate stakeholder questions. CECL adoption will require most banks to take a one-time capital charge to adjust the allowance. Executives will need to explain this charge to internal and external stakeholders. Moving from a rate versus volume attribution to a more complex set of drivers of the allowance estimate, including the incorporation of forecasted conditions, will require the production of additional analytics to properly assess and report on the change. Executives will need ensure their bank has proper reporting framework and structure to produce analytics at the portfolio, segment and, ultimately, loan level.