Trying to Face Down CECL

When Ed Robertson, a managing director at the real estate valuation and consulting firm Situs, talks to banks about the data they need to comply with the new Current Expected Credit Loss standard, he estimates that only one out of 75 has what’s needed. “The rest of them look at me like a deer in the headlights,” he says.

Welcome to the new Financial Accounting Standards Board’s CECL rule, as it’s known, the most significant accounting change for banks in decades. The new rule is intended to help investors get a better idea of the risk in the loan portfolio by requiring banks to reserve for losses over the life of the credits, and set aside loss reserves as soon as they book the loans based on reasonable and supportable conclusions. Instead of projecting losses out 12 months, as is common under the current incurred loss model, banks and other financial institutions will need to start predicting losses based on contractual life, even if loan terms are seven or 10 years. Held-to-maturity securities also are within the scope of the standard.

What this will mean for any one bank is anyone’s guess. The new standard goes into effect for public entities in 2020, and for private ones the following year. That means banks are preparing now, putting together project timelines and looking for gaps in their data, so they can run two sets of numbers during a portion of 2019 and start figuring out what the new rule’s impact will be. CECL is going to require either staff resources, or some outside help. Many banks already have a plan in place, including a timeline with specific responsibilities assigned to members of their CECL implementation team. Additionally, some banks already have started the process of selecting software vendors that will provide the models necessary to quantify loan losses for specific pools of loans. Others are falling behind in implementation.

It will be important for members of a bank board to ask specific questions to make sure their bank is on track to comply with the new accounting standard, and not get any surprises in terms of an unexpected need to raise capital or a hit to earnings.

The new accounting approach focuses on one of the most important calculations in banking: the allowance for loan losses. Projecting what a bank’s losses are going to be, and providing a cushion for them, is a delicate balance. Socking away too much can unnecessarily hurt earnings or even regulatory capital. Underestimating losses, on the other hand, can make investors angry when the bank has to suddenly increase reserves.

Robertson came out with the alarming conclusion that the average bank under CECL will have to double its allowance for loan losses, from 1 or 1.5 percent of loans to 3 or 4 percent. Not everybody has such high estimates. Management teams at publicly traded banks have given out estimates of a manageable 10 to 50 percent increase in loan loss reserves as a result of the new standard, says Matthew Clark, a senior research analyst at Piper Jaffray & Co. He does not expect a lot of banks to raise capital as a result, because banks already have plenty of capital and the tax cuts this year will help increase earnings. But the truth is that nobody knows for sure. “The most common answer is: It’s early,” he says. “Nobody really has concrete answers.”

Another possibility is that banks using more precise calculations for loan losses will start charging higher interest rates on loans that have longer terms and more risk. “It’s going to make banks shy away from riskier asset classes,” Clark says.

That’s not necessarily a bad thing. Mark Oldenberg, the chief financial officer for Peoples State Bank, an $845 million asset bank in Wausau, Wisconsin, thinks the bank will better predict losses and price risk in the loan portfolio after the process is complete. “I think it’s going to be a challenge in getting the right data fields and getting [the bank’s new] software running,” he says. “There are also opportunities to drive better information than we’ve had before.”

Until now, the calculation for an allowance has been relatively simple at banks such as Peoples State, but banks are going to find themselves running multiple models on different loan pools, based on the risk characteristics and term of the loans. That will complicate the calculations. “A lot of institutions don’t have people with 5 to 10 [extra] hours per week to think about CECL,” says Brett Schwantes, senior manager for the financial institutions practice at accounting firm Wipfli. Banks should determine whether they are going to purchase models from third-party vendors for determining loan losses, and start doing interviews with potential vendors. Banks that do acquisitions will have to consider the impact of CECL as well.

It’s possible to do a simple calculation using only one model, but that’s like painting with a broad brush instead of a fine brush, says Stephen Wagner, a partner at the accounting and consulting firm Crowe Horwath LLP. A fine brush would give you a more specific, and accurate outcome. If you go with one model for all your loans, you’re bound to end up with a higher allowance for loan losses than you need.

Some banks still are suffering from denial, and haven’t gotten started with CECL planning and implementation. That’s a problem because banks that are late to the game may find themselves without time to adjust to the need for more capital. “Some of them still believe this is going to be repealed,” says Schwantes. “That’s not happening.”

Others, especially public banks above $10 billion in assets, are well on their way to implementing the new standard, says John Behringer, a partner in the audit, tax and consulting firm RSM. Most public banks from $1 billion to $10 billion in assets already have a project timeline and a high level plan for implementation, even if the details aren’t all worked out. They are looking through their data to determine the gaps, he says. “I think if you haven’t started the data analysis, you are behind,” Behringer says.

Given these challenges, bank boards need to make sure their banks have the resources they need and have gotten started on the planning process. Public banks will have less time to comply than private banks, and will have more pressure from investors to start answering questions, possibly as early as this year, about the potential impact of CECL on earnings and capital. “This is a huge project,” Schwantes says.

Questions That Directors Should Ask About CECL

Q: What’s the bank’s plan to implement CECL?
By now, public banks should have at least a high-level plan and timeline of implementation, with assigned responsibilities for a cross-functional team that will examine the new rule’s impact on a variety of areas including credit, information technology, compliance, internal audit and risk management. The joke is that pretty much everyone is involved in CECL in some way, except “your tax department and your deposit department,” says Wagner.

Q: Do we have the resources to do this internally?
Try to get a serious answer to this question. If critical staff are working 50 hours per week, and don’t have an extra 10 hours per week to prepare, your bank needs to figure out how to accomplish the change. Some banks will use third parties for consulting work or to purchase models, and if so, what is the plan to select and manage those vendors?

Q: What progress has the bank made to date?
It’s important to assess whether your bank is meeting appropriate targets for compliance and gathering information. Has the bank begun an analysis of what data it will need and what data is missing, and how does the bank intend to fill those gaps? Public banks, which have to start reporting in 2020, will want to run parallel books in 2019 under the old and new standard to better assess the impact and prepare for it.

Q: Are we communicating with outside parties?
Regulators and external auditors will be interested in your bank’s implementation of CECL and will have to sign off on your bank’s decisions, Schwantes says. Management teams should be in communication with outside parties to ensure a smooth transition.

Q: What is the potential impact on earnings and capital?
Probably the most important question for a bank’s board is how the CECL standard will impact earnings and capital, and this will also be the most difficult to answer right away. Getting prepared if there is a need for more capital means fewer surprises for investors and the board.

Q: What will this do to M&A transactions?
CECL will impact mergers and acquisitions, as banks will have to use the new standard to account for acquired loans. Banks may find themselves less interested in riskier or long-term loans, or want to be compensated for the hit to capital and earnings as a result of booking those loans.