CECL: Navigating Regulatory Expectations

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CECL-11-24-17.pngThe issuance of the new current expected credit loss (CECL) standard in June 2016 represents a substantial accounting change, and many boards are trying to determine how their institutions will comply with the new standard. In Frequently Asked Questions on the New Accounting Standard on Financial Instruments—Credit Losses, the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corp. and National Credit Union Administration (collectively, the Agencies) state that they expect supervised institutions to make good-faith efforts to implement the new accounting standard in a sound and reasonable manner. Given the likely expectation that CECL will increase allowance levels and lower capital, regulatory expectations will be heightened.

Significant changes in the Allowance for Loan and Lease Losses (ALLL) are not unique. Institutions can look back just 20 years and recognize regulatory guidance that looked at percentages of classified loans as a measure of ALLL adequacy irrespective of the methodology chosen under generally accepted accounting principles (GAAP). Refinements in 2001 and 2006 furnished guidelines of acceptable ALLL methodologies to provide consistency for GAAP and regulatory purposes. Although mathematically accurate, as seen with the recent financial crisis and long recovery period, it’s becoming increasingly difficult to measure and react to changing economic conditions.

A noted benefit to the new standard is the flexibility in determining expected losses. The Agencies recognize this flexibility, but institutions should use judgment in developing estimation methods. Any method chosen should be well-documented, applied consistently over time and provide a good-faith estimate to the collectability of financial assets. Further, the Agencies have commented that smaller and less complex institutions will be able to adjust their existing allowance methods to meet the new accounting standard’s requirements without the use of costly, complex models.

So how do financial institutions focus on getting this methodology change right, and what should the board be focused on?

The board of directors plays a pivotal role in the effective governance of its institution by overseeing management and providing organizational leadership through core corporate values. This helps keep the institution operating in a safe and sound manner, and comply with applicable laws and regulations. Directors are not expected to be actively involved in day-to-day operations, but should provide clear guidance and monitor risk exposure through established policies, procedures and practices. The board, typically through an established audit committee, has broad oversight to monitor the financial reporting process and oversee the financial institution’s establishment of accounting policies and practices. In anticipation of implementing CECL, the board should consider reviewing the significant qualitative aspects of the bank’s accounting practices, including accounting estimates, financial reporting judgments and financial statement disclosures.

Existing regulatory guidance provides a roadmap of expectations regarding the ALLL methodology, and expectations will likely remain unchanged with the new CECL standard. The guidance states that for an institution’s ALLL methodology to be effective, the institution’s written policies and procedures should address:

  • The roles and responsibilities of bank personnel involved in the ALLL process,
  • The institution’s accounting policies affecting the ALLL,
  • A narrative of the institution’s methodology, and
  • Documentation of the internal controls used in the ALLL process.

Some institutions are considering the use of third-party vendors for CECL implementation, and in this case, boards should ensure their institutions have appropriate processes in place for selecting vendor models. As part of this process, institutions should require that the vendors provide developmental evidence explaining the product components, its design and proof that the product works as expected, with an understanding of the model’s limitations. Whether the model is developed in-house or by a vendor, all model components, including input, processing and reporting, should be subject to an independent validation that’s consistent with current regulatory guidance. Also, depending on the complexity of the method chosen, certain models likely will be within the scope of the Agencies’ model risk management guidelines, and institutions will need to consider ways to effectively challenge those new models.

Boards should become familiar with the new standard and work with management to understand the plan to implement it, based on the institution’s size and complexity prior to the applicable effective date. Boards should also make sure they’re regularly updated on the status of implementation efforts. It’s expected that examiners will begin to inquire about the status of institutions’ implementation efforts and as the effective date nears, examiners will want to know the new standard’s effect on the bank’s capital levels.

Implementing CECL will be a significant challenge for institutions that aren’t diligent and timely in creating and executing a plan with input from many key stakeholders—including the board. Active participation on the part of directors will be critical in its success.

Using Big Data to Assess Credit Quality for CECL

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CECL-4-7-17.pngThe new Financial Accounting Standards Board (FASB) rules for estimating expected credit losses presents banks with a wide variety of challenges as they work toward compliance.

New Calculation Methods Require New Data
The new FASB standard replaces the incurred loss model for estimating credit losses with the new current expected credit loss (CECL) model. Although the new model will apply to many types of financial assets that are measured at amortized cost, the largest impact for many lenders will be on the allowance for loan and lease losses (ALLL).

Under the CECL model, reporting organizations will make adjustments to their historical loss picture to highlight differences between the risk characteristics of their current portfolio and the risk characteristics of the assets on which their historical losses are based. The information considered includes prior portfolio composition, past events that affected the historic loss, management’s assessment of current conditions and current portfolio composition, and forecast information that the FASB describes as reasonable and supportable.

To develop and support the expected credit losses and any adjustments to historical loss data, banks will need to access a wider array of data that is more forward-looking than the simpler incurred loss model.

Internal Data Inventory: The Clock is Running
Although most of the data needed to perform these various pooling, disclosure and expected credit loss calculations can be found somewhere, in some form, within most bank’s systems, these disparate systems generally are not well integrated. In addition, many data points such as customer financial ratios and other credit loss characteristics are regularly updated and replaced, which can make it impossible to track the historical data needed for determining trends and calculating adjustments. Other customer-specific credit loss characteristics that may be used in loan origination today might not be updated to enable use in expected credit loss models in the future.

Regardless of the specific deadlines that apply to each type of entity, all organizations should start capturing and retaining certain types of financial asset and credit data. These data fields must be captured and maintained permanently over the life of each asset in order to enable appropriate pooling and disclosure and to establish the historical performance trends and loss patterns that will be needed to perform the new expected loss calculations. Internal data elements should focus on risks identified in the portfolio and modeling techniques the organization finds best suited for measuring the risks.

External Economic Data
In addition to locating, capturing, and retaining internal loan portfolio data, banks also must make adjustments to reflect how current conditions and reasonable and supportable forecasts differ from the conditions that existed when the historical loss information was evaluated.

A variety of external macroeconomic conditions can affect expected portfolio performance. Although a few of the largest national banking organizations engage in sophisticated economic forecasting, the vast majority of banks will need to access reliable information from external sources that meet the definition of “reasonable and supportable.”

A good place to start is by reviewing the baseline domestic macroeconomic variables provided by the Office of the Comptroller of the Currency (OCC) for Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank stress testing (DFAST) purposes. Because regulators use these variables to develop economic scenarios, these variables would seem to provide a reasonable starting point for obtaining potentially relevant historic economic variables and considerations from the regulatory perspective of baseline future economic conditions.

Broad national metrics—such as disposable income growth, unemployment, and housing prices—need to be augmented by comparable local and regional indexes. Data from sources such as the Federal Deposit Insurance Corporation’s quarterly Consolidated Report of Condition and Income (otherwise known as the call report) and Federal Reserve Economic Data (FRED), maintained by the Federal Reserve Bank of St. Louis, also can be useful.

Data List for CECL Compliance

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Looking Beyond Compliance
The new FASB reporting standard for credit losses will require banks to present expected losses in a timelier manner, which in turn will provide investors with better information about expected losses. While this new standard presents organizations of all sizes with some significant initial compliance challenges, it also can be viewed as an opportunity to improve performance and upgrade management capabilities.

By understanding the current availability and limitations of portfolio data and by improving the reliability and accuracy of various data elements, banks can be prepared to manage their portfolios in a way that improves income and maximizes capital efficiency.

Is Your Bank Increasing Its Credit Risk?

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9-22-14-Covington.pngOn June 25, 2014, the Office of the Comptroller of the Currency (OCC) released its Semiannual Risk Perspective, which identified key credit risk threats to the safety and soundness of banks. The OCC report stated that while some credit risk metrics (such as noncurrent loans and net charge-offs) showed improvement in 2013, credit risk appeared to be increasing in leveraged loans and auto loan portfolios. Other regulators have expressed similar concerns about the level of credit risk in bank loan portfolios.

The issuance of syndicated leveraged loans (i.e., corporate debt instruments issued to a group of lenders) reached a record high in 2013, driven by an increased risk appetite caused by the low interest rate environment. The OCC’s recent examinations of these and other commercial loan portfolios found that credit policies were being relaxed, largely in response to competitive pressures. Borrowers have increasingly demanded what are known as “covenant lite” leveraged loans, which have fewer covenants and lender protections, and many lenders have responded with more liberal underwriting standards.

Examiners also identified the loosening of credit standards and increased layering of risk (such as increasing collateral advance rates and waiving or loosening guarantees) for indirect auto loans. Average loan-to-value rates for vehicles are now above 100 percent, reflecting rising car prices and a greater bundling of add-on products (such as extended warranties, credit life insurance and aftermarket accessories) into financing. Moreover, the average loss per vehicle has risen substantially.

As a result of these changes in both the leveraged loan and auto loan sectors, the OCC intends to scrutinize banks’ underwriting standards more carefully and is encouraging banks to assess their credit risk appetite.

While the OCC’s report does not foreshadow widespread credit quality issues across the banking industry, bank directors should nonetheless heed the report’s warnings and review credit risk metrics—especially with respect to leveraged loan and auto loan portfolios—to determine whether their banks’ credit risk is trending upward. If credit risk is increasing, the bank should ensure that its risk management program is sufficient to capture and address this increased risk. For example, the bank should review its underwriting criteria to determine the factors that counter-balance the increased risk for these types of loans.

Similarly, the bank should ensure that it has appropriate ongoing monitoring so that action can be taken on individual credits as soon as the bank detects any softening in the borrower’s credit profile. Other functions, such as the bank’s allowance for loan and lease losses (ALLL) and management information systems (MIS), also should be reviewed to ensure that they are supporting the credit risk management function. Any increased credit risk should be reflected in the ALLL and should be monitored through formal MIS reporting.

In developing a risk management program to mitigate credit risk, banks also should pay special attention to guidance from the banking agencies relating to lending, including guidance specifically applicable to leveraged lending and auto lending. In March 2013, for example, the federal banking agencies finalized their interagency leveraged lending guidance, which has imposed greater regulation on such lending. The guidance includes requirements for underwriting, risk rating, credit management, portfolio and pipeline stress testing, as well as problem credit management. More generally, the guidance is quite broad and gives the agencies significant discretion in applying and enforcing its standards. Since last fall, the agencies have been examining banks’ compliance with the guidance. For that reason and because credit risk on these loans is increasing, a bank that is engaged in leveraged lending should monitor its portfolio to ensure compliance with the guidance.

The OCC’s report is a preemptive warning of trends that have the potential to turn into greater concerns. Increased competition and the low interest rate environment have spurred banks to relax leveraged lending and auto lending underwriting standards, and the OCC has observed that these trends may not be reversing in the near future. Bank directors should determine whether their institutions are affected by increased credit risk and, if so, oversee processes to mitigate such risk. By doing so, increases in credit risk can be effectively monitored and addressed without becoming greater problems for the bank down the road.