When Rates are Zero, Derivatives Make Every Basis Point Count

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It’s been one quarter after another of surprises from the Federal Reserve Board.

After shocking many forecasters in 2019 by making three quarter-point cuts to its benchmark interest rate target, the data-dependent Fed was widely thought to be on hold entering 2020. But the quick onset of the coronavirus pandemic hitting the United States in March 2020 quickly rendered banks’ forecasts for stable rates useless. The Fed has acted aggressively to provide liquidity, sending its benchmark back to the zero-bound range, where rates last languished from 2008 to 2015.

During those seven years of zero percent interest rates, banks learned two important lessons:

  1. The impact of a single basis point change in the yield of an asset or the rate paid on a funding instrument is more material when starting from a lower base. In times like these, it pays to be vigilant when considering available choices in loans and investments on the asset side of the balance sheet, and in deposits and borrowings on liability side.
  2. Even when we think we know what is going to happen next, we really don’t know. There was an annual chorus in the early and mid-2010s: “This is the year for higher rates.” Everyone believed that the next move would certainly be higher than the last one. In reality, short-rates remained frozen near zero for years, while multiple rounds of quantitative easing from the Fed pushed long-rates lower and the yield curve flatter before “lift off” finally began in 2015.

The most effective tools to capture every basis point and trade uncertainty for certainty are interest rate derivatives. Liquidity and funding questions have taken center stage, given the uncertainty around loan originations, payment deferrals and deposit flows. In the current environment, banks with access to traditional swaps, caps and floors can separate decisions about rate protection from decisions about  funding/liquidity and realize meaningful savings in the process.

To illustrate: A bank looking to access the wholesale funding market might typically start with fixed-rate advances from their Federal Home Loan Bank. These instruments are essentially a bundled product consisting of liquidity and interest rate protection benefits; the cost of each component is rolled into the quoted advance rate. By choosing to access short-term funding instead, a bank can then execute an interest rate swap or cap to hedge the re-pricing risk that occurs each time the funding rolls over. Separating funding from rate protection enables the bank to save the liquidity premium built into the fixed-rate advance.

Some potential benefits of utilizing derivatives in the funding process include:

  • Using a swap can save an estimated 25 to 75 basis points compared to the like-term fixed-rate advance.
  • In early April 2020, certain swap strategies tied to 3-month LIBOR enabled banks to access negative net funding costs for the first reset period of the hedge.
  • Swaps have a symmetric prepayment characteristic built-in; standard fixed-rate advances include a one-way penalty if rates are lower.
  • In addition to LIBOR, swaps can be executed using the effective Fed Funds rate in tandem with an overnight borrowing position.
  • Interest rate caps can be used to enjoy current low borrowing rates for as long as they last, while offering the comfort of an upper limit in the cap strike.

Many community banks that want to compete for fixed-rate loans with terms of 10 years or more but view derivatives as too complex have opted to engage in indirect/third-party swap programs. These programs place their borrowers into a derivative, while remaining “derivative-free” themselves. In addition to leaving significant revenue on the table, those taking this “toe-in-the-water” approach miss out on the opportunity to utilize derivatives to reduce funding costs. 

While accounting concerns are the No. 1 reason cited by community banks for avoiding traditional interest rate derivatives, recent changes from the Financial Accounting Standards Board have completely overhauled this narrative. For banks that have steered clear of swaps — thinking they are too risky or not worth the effort — an education session that identifies the actual risks while providing solutions to manage and minimize those risks can help a board and management team separate facts from fears and make the best decision for their institution.

With the recent return to rock-bottom interest rates, maintaining a laser focus on funding costs is more critical than ever. A financial institution with hedging capabilities installed in the risk management toolkit is better equipped to protect its net interest margin and make every basis point count.

CECL Delay Opens Window for Risk Improvements

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The delay in the current expected credit loss accounting model has created a window of opportunity for small banks.

The delay from the Financial Accounting Standards Board created two buckets of institutions. Most of the former “wave 1” institutions constitute the new bucket 1 group with a 2020 start. The second bucket, which now includes all former “wave 2 and 3” companies are pushed back to 2023 — giving these institutions the time required to optimize their approach to the regulation.

Industry concerns about CECL have focused on two of its six major steps: the requirement of a reasonable and supportable economic forecast and the expected credit loss calculation itself. It’s important to note that most core elements of the process are consistent with current industry best practices. However, they may take more time for banks to do it right than previously thought.

Auditors and examiners have long focused on the core of CECL’s six steps — data management and process governance, credit risk assessment, accounting, and disclosure and analytics. Financial institutions that choose to keep their pre-CECL process for these steps do so at their own peril, and risk falling behind competitors or heightened costs in a late rush to compliance. Strategically minded institutions, however, are forging ahead with these core aspects of CECL so they can fully vet all approaches, shore up any deficiencies and maintain business as usual before their effective date.

Discussions over the impact of the CECL standard continue, including the potential for changes as the impacts from CECL bucket 1 filings are analyzed. Unknown changes, coupled with a three-year deadline, could easily lead to procrastination. Acting now to build a framework designed to handle the inevitable accounting and regulatory changes will give your bank the opportunity to begin CECL compliance with confidence and create a competitive advantage over your lagging peers.

Centering CECL practices as the core of a larger management information system gives institutions a way to improve their risk assessment and mitigation strategies and grow business while balancing risk and return. More widely, institutions can align the execution across the organization, engaging both management and shareholders.

Institutions can use their CECL preparations to establish an end-to-end credit risk management framework within the organization and enjoy strategic, incremental improvements across a range of functions — improving decision making and setting the stage for future standards. This can yield benefits in several areas.

Data management and quality: Firms starting to build their data histories with credit risk factors now can improve their current Allowance for Loan and Lease Losses process to ensure the successful implementation of CECL. Financial institutions frequently underestimate the time and effort required to put the required data and data management structures in place, particularly with respect to granularity and quality. For higher quality data, start sourcing data now.

Integration of risk and financial analysis: This can strengthen the risk modeling and provisioning process, leading to an improved understanding and management of credit quality. It also results in more appropriate provisions under the standard and can give an early warning of the potential impact. Improved communication between the risk and finance functions can lead to shared terminologies, methods and approaches, thereby building governance and bridges between the functions.

Analytics and transparency: Firms can run what-if scenario analysis from a risk and finance perspective, and then slice and dice, filter or otherwise decompose the results to understand the drivers of changes in performance. This transparency can then be used to drive firms’ business scenario management processes.

Audit and governance: Firms can leverage their CECL preparations to adopt an end-to-end credit risk management architecture (enterprise class and cloud-enabled) capable not only of handling quantitative compliance to address qualitative concerns and empower institutions to better answer questions from auditors, management and regulators. This approach addresses weaknesses in current processes that have been discovered by audit and regulators.

Business scenario management: Financial institutions can leverage these steps to quantify the impact of CECL on their business before regulatory deadlines, giving them a competitive advantage as others catch up. Mapping risks to potential rewards allows firms to improve returns for the firm.

Firms can benefit from CECL best practices now, since they are equally applicable to the current incurred loss process. Implementing them allows firms to continue building on their integration of risk and finance, improving their ALLL processes as they do. At the same time, they can build a more granular and higher quality historical credit risk database for the transition to the new CECL standards, whatever the timeframe. This ensures a smoother transition to CECL and minimizes the risk of nasty surprises along the way.

Coronavirus Sparks CECL Uncertainty

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Even before COVID-19, the first quarter of 2020 was shaping up to be an uncertain one for large public banks. Now, it could be a disaster.

There is broad concern that the current expected credit loss standard, which has been effective since the start of 2020 for big banks, will aggravate an already bad situation by discouraging lending and loan modification efforts just when the new coronavirus is wreaking havoc on the economy. Congress is poised to offer banks temporary relief from the standard as a part of its broader relief act.

Section 4014 of the Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, would give insured depository institutions and bank holding companies the option of temporarily delaying CECL implementation until Dec. 31, 2020, or “the date on which the public emergency declaration related to coronavirus is terminated.”

Congress’ bill comes as the Financial Accounting Standards Board has already rebuffed the efforts of one regulator to delay the standard.

On March 19, Federal Deposit Insurance Corp. Chairman Jelena McWilliams sent a letter to the board seeking, among other requests, a postponement of CECL implementation for banks currently subject to the standard and a moratorium for banks with the 2023 effective date.

McWilliams wrote that a moratorium would “allow these financial institutions to focus on immediate business challenges relating to the impacts of the current pandemic and its effect on the financial system.”

FASB declined to act on both proposals. “We’re continuing to work with financial institutions to understand their specific challenges in implementing the CECL standard,” wrote spokesperson Christine Klimek in an email to me later that day.

It’s not an overstatement to say that the standard’s reporting effective date could not come at a worse time for banks — or that a potential delay necessitating a switch back to the incurred loss model may be a major undertaking for banks scheduled to report results in the next several weeks.

“Banks are being tasked with something pretty complex in a very short timeframe. And of course, this is the first period that they’re including these numbers and a lot of the processes are brand new,” says Reza Van Roosmalen, a principal at KPMG who leads the firm’s efforts for financial instruments accounting change. “They’ve practiced with parallel runs. But you’re immediately going to the finals without having had any other games. This is the hardest situation you could be in.”

CECL has been in effect since the start of the new year for large banks and its impact was finally expected to show up in first-quarter results. But the pandemic and related economic crisis creates major implications for banks’ allowances and could potentially influence their lending behavior.

The standard requires banks to reserve lifetime loan losses at origination. Banks took a one-time adjustment to increase their reserves to reflect the lifetime losses of all existing loans when they switched to the standard, deducting the amount from capital with the option to phase-in the impact over three years. Afterwards, they adjusted their reserves using earning as new loans came onto the books, or as their economic forecasts or borrowers’ financial conditions changed. The rapid spread and deep impact of COVID-19, the bulk of which has been experienced by the U.S. in March, has led to a precipitous economic decline and interest rate freefall. Regulators are now encouraging banks to work with borrowers facing financial hardship.

“For banks, [CECL is] going to be a true test for them. It’s not just going through this accounting standard in the macroeconomic scenario that we’re in,” says Will Neeriemer, a partner in DHG’s financial services group, pointing out that the change comes as many bankers adjust to working from home or in shifts to keep operations running. “That is almost as challenging for them as going through the new standard for the first time in a live environment.”

The concern is that CECL will force allowances to jump once more at the beginning of the standard as once-performing loans become troubled all at the same time. That could discourage new lending activity — leading to procyclical behavior that mirrors, rather than counters, economic peaks and troughs.

It remains to be seen if that would happen if Congress doesn’t provide temporary accounting and provisioning relief, or if some banks decline the temporary relief and report their results under CECL. Regardless, the quarter will be challenging for banks.

“It’s temporary relief and it’s only for this year. It keeps the status quo, which I think is important,” says Lawrence Kaplan, chair of the bank regulatory group in Paul Hasting’s global banking and payments systems practice. “You don’t have to have artificial, unintended consequences because we’re switching to a new accounting standard during a period where there are other extraordinary events.”

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 Ready for CECL?

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CECL-12-28-16.pngConsidered by some bank accounting’s most significant change in 40 years, the FASB’s Current Expected Credit Loss (CECL) standard is inching toward reality.

Are you and your board colleagues studying the standard’s fundamentally new requirements for booking loan losses? Do you have a sense for its implications on reserves? Are you considering the penetrating questions to ask about management’s preparedness and processes to comply?

For some directors, the standard might seem straightforward: Build reserves to cover losses over the life of a loan. But it means much more: The timing of adding to the reserve has changed considerably. The entire expected lifetime losses must be booked in the quarter in which the loan is made.

Make no mistake; preparing to meet the demands of the standard, effective January 1, 2020, for most Securities and Exchange Commission (SEC) registrants, promises be a complex, time-consuming endeavor.

Other questions bank directors must ask themselves include whether they understand the standard’s implications and if they are confident that bank management is prepared for the formidable changes affecting modeling, data collection and analysis, calculation of losses, and information technology (IT) systems.

For some bank management teams, the answer may be a confident, “Yes.’’ For others, it might be a tentative, “Well … let us get back to you on that.’’

It is worth noting that 83 percent of bankers who answered a recent survey at the American Institute of Certified Public Accountants conference said they expected CECL to require substantial changes to banks’ policies, procedures and IT systems. Half said they were most concerned about how they would manage the amount of data needed to comply.

Consider this counterintuitive CECL scenario: the bank has a quarter it considers successful because of the number of new organically grown loans it made. But, it might show a quarterly loss because the bank must book expected losses for the entire life of those loans in the quarter in which the loans were made. Under current rules, banks book losses after they are incurred.

Further, when calculating expected losses under CECL, banks must incorporate reasonable and supportable forecasts in their loss evaluations. In other words, how strong are your bank’s modeling capabilities?

That forecast would include a bank’s expectation, for example, of the future yield curve and an expectation of the economic future over the life of the loan–and how these factors would impact the performance of each loan for the life of the loan.

For some banks, the timing issue could mean between now and 2020, they will need to add to their capital base through earnings. Capital planning considerations are most effectively dealt with when given sufficient lead time, especially if a number of institutions need to raise capital upon adoption of the standard.

Directors must prepare to challenge management’s process to meet the standard. That may mean that directors ask management if they’ve examined commercial loans by type or vintage, and if they’ve done preliminary lifetime loss calculations based on past experience and future economic considerations.

Consequently, directors need comfort that management has established a robust CECL planning process in order to know which data will be required. It’s no wonder, then, that for many directors, that standard looming on the horizon suddenly is getting closer.

The Board’s Role in the Transition to CECL

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CECL-9-30-16.pngThis summer, the Financial Accounting Standards Board (FASB) completed its project on credit losses with the issuance of a new standard that brings one of the most significant changes to financial reporting that financial institutions have seen in decades: The incurred loss model for estimating credit losses will be replaced with a new model, the current expected credit loss (CECL) model. In many cases, the new credit loss calculations are expected to result in an increase in the allowance, and, thus, might have a significant impact on capital requirements. Banks will need sufficient time to prepare and adjust capital planning and capital management strategies.

Banks are educating themselves on the changes, and boards of directors should be aware of the challenges faced by the banks they oversee.

As with any major initiative, a successful transition to the new standard will require the active involvement of the audit committee, the board of directors, and senior management. Given the audit committee’s responsibility for overseeing financial reporting, it has a critical role to play in overseeing implementation.

Recently, speakers from the Securities and Exchange Commission’s (SEC’s) Office of the Chief Accountant have emphasized the role that audit committees should have in implementing new significant accounting standards. In his speeches at Baruch College and the AICPA Bank Conference, Wes Bricker, interim chief accountant, addressed CECL implementation. Likewise, the federal financial institution regulatory agencies have addressed the role of the board in implementing the new credit loss standard. The agencies issued a joint statement on June 17, and in March the Federal Reserve System (Fed) released an article, “New Rules on Accounting for Credit Losses Coming Soon.” The speeches, joint statement, and article highlight tasks that boards of directors and audit committees may consider during transition, including:

  • Evaluate management’s implementation plan, including the qualified resources allocated for execution.
  • Monitor the progress of the implementation plan, including any concerns raised by the auditors or management that might affect future financial reporting.
  • Understand the changes to the accounting policies that are required for implementation.
  • Understand management’s transition to any new information systems, modeling methodologies, or processes that might be necessary to capture the data to implement the standard.
  • Oversee any changes to internal control over financial reporting in transitioning to the new standard.
  • Review impact assessments of the new standards, including impact on financial statements; key performance metrics, including credit loss ratios, that might be disclosed to investors outside the financial statements; regulatory capital; and other aspects of the organization such as compensation arrangements and tax-planning strategies.
  • Understand management’s plan to communicate the impact of the new standard on key stakeholders, including the new disclosures required by the standards and disclosures made leading up to the adoption date. Those who file with the SEC will need to disclose information about standards effective in future periods, including the expected impact when adopted.

In evaluating management’s implementation plan, it is important to develop an understanding of management’s timeline for implementing the new standards and to be aware of the effective date. Recognizing that the definition of a public business entity (PBE) under FASB includes many financial service entities, the FASB split the definition to provide additional time for PBEs that are not SEC filers.

  • For PBEs that are SEC filers, the standard is effective in fiscal years beginning after Dec. 15, 2019, and interim periods in those fiscal years. For calendar year-end SEC filers, it first applies to the March 31, 2020, interim financial statements.
  • For PBEs that are not SEC filers, the standard is effective in fiscal years beginning after Dec. 15, 2020.
  • For all other entities, the effective date includes fiscal years beginning after Dec. 15, 2020, and interim periods in fiscal years beginning after Dec. 15, 2021.
  • Early adoption is permitted for all entities in fiscal years beginning after Dec. 15, 2018, and interim periods in those fiscal years. That means, any calendar year-end entity may adopt as early as the March 31, 2019, interim financial statements.

While those dates might seem somewhat distant, there really is no time to lose in preparing for the transition.

Top Trends Impacting Audit Committees in 2016

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audit-committee-6-10-16.pngIf you’re serving on an audit committee, congratulations. That may be the toughest and most time consuming committee of a bank board. If you find that it isn’t getting any easier, you’re not alone.

As Bank Director gears up for next week’s Bank Audit & Risk Committees Conference in Chicago, we spoke to accountants and consultants who advise banks on the biggest trends impacting audit committees this year.

Audit committees are clamoring to learn how to be more strategic. Jennifer Burke, a partner at Crowe Horwath LLP, says she gets lots of questions from audit committees about how they should focus more on big picture issues, and not get bogged down in all the details. They have the usual responsibilities: supervising an internal auditor, hiring an external auditor, reviewing audits and following up to make sure problems are fixed, but they have a lot more to keep track of as well, including a widening array of new regulations and accounting pronouncements, as well as, in some cases, risk management and cyber risk issues. “It’s not easy to be on an audit committee these days,’’ she says. “There’s not a box to check to make sure your bank will survive.”

Audit committees will begin asking questions about the implementation of Financial Accounting Standards Board (FASB)’s new standard on loan loss impairment. The organization is expected to publish final rules in the next week or two for what’s known as the Current Expected Credit Loss Impairment Model (CECL). “It’s the biggest accounting change for banks we’ve seen in a decade,’’ says Carol Larson, a partner at Deloitte & Touche LLP. Under the current incurred loss model, banks reserve for loan losses based on incurred losses. Under CECL, which is expected to go into effect in 2020, banks will have to reserve for estimated losses over the life of the loan, based on the experience with other, similar types of loans. As soon as a bank makes a loan, it will likely have to record a reserve for that loan. “Banks don’t like this model we’re moving to,’’ Larson says. “It’s going to significantly increase their reserves. You can imagine regulators really like it a lot.” Since banks will want to run the new model for a year in advance of the rule going into effect, Larson suggests banks should try to have a concrete plan and timeline for implementation this fall.

Audit committees increasingly burdened with bank-related compliance issues are trying to be more efficient. Larson says boards often hand over compliance-related problems and oversight of new regulations to audit committees, which have seen such work escalate since the financial crisis. It used to be fairly uncommon for a bank to get hit with a regulatory “matters requiring attention” notice. Now, it’s fairly common for a bank to have 20, Larson says. “It’s mind numbing on some level,’’ she says. It’s fair for an audit committee to ask questions not just about adding employees to the compliance department, but how to add them efficiently. Perhaps the old way of doing business is no longer the most efficient way, and data analytics could help banks in some ways handle the compliance burden effectively.

Cyber risk is a huge concern. Bank boards are worried about cyber security, there’s no doubt about it, and much of this oversight is handled at the audit committee level, especially for smaller banks. About 28 percent of bank audit committees handle cyber risk in the audit committee, with smaller banks more likely to handle this in audit than banks over $5 billion in assets, according to Bank Director’s 2016 Risk Practices Survey. A good practice is not to assume you can plug every leak, but to get prepared for the almost inevitable data breach, Larson says. Just like a natural disaster, data breaches aren’t necessarily preventable, but you can prepare with a good disaster plan.

FASB’s New Standards for Financial Instruments: What Banks Need to Know

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FASB-2-15-16.pngAt 232 pages, Accounting Standards Update (ASU) No. 2016-01, issued in January of 2016, might be intimidating, but we will boil down the essentials you need to know as a bank accountant, chief financial officer, or member of an audit committee. In 2010, the Financial Accounting Standards Board (FASB) issued a massive proposal with many significant changes including marking the majority of a bank’s balance sheet (securities, loans and deposits) to fair value. The FASB has come a long way since then and completes part one of its financial instruments project with the issuance of this standard. When boiled down, the standard contains eight or nine significant changes of interest to banks. Not every bank will be affected by all of the changes, and whether you view these changes as positive or negative depends upon whether you are a preparer or user.

Two of the changes—both of which the banking industry views as favorable—may be adopted early for financial statements not yet issued:

  • Liabilities using the fair value option: Under current generally accepted accounting principles (GAAP), the change in fair value resulting from instrument-specific credit risk is presented in earnings, which has an interesting result. As a bank’s own credit worthiness declines, income is recorded because the value of the liability declines, usually the bank’s debt. Many found that to be an odd outcome—and the FASB agreed. This ASU corrects that and those changes now will be recorded in other comprehensive income (OCI) instead of earnings, and consistent with regulatory capital treatment.
  • Disclosures of fair value of financial instruments: In an effort to provide relief, the FASB is dropping this requirement, which was born in Financial Accounting Standards (FAS) No. 107, for non-public business entities (non-PBEs). Beware, though: The definition of PBE is very broad and extends far beyond those who file with the SEC. Many banks have been surprised to learn they are considered to be PBEs.

The most significant change is that PBEs will have to calculate fair values using the exit price notion, obtaining a fair value using what a market participant would use. This is a big deal because under current GAAP, there is a provision that permits banks to calculate these fair values using a discounted cash flow approach known as entrance pricing. For example, the fair value of loans commonly is computed by discounting the cash flows using the current rates at which similar loans would be made to borrowers with mirroring credit ratings and remaining maturities. Requiring exit pricing could prove challenging, particularly for loans. A small but positive change for PBEs is the elimination of the requirement to disclose the methods and significant assumptions used.

The next big area of change is for equity investments, with general exceptions for those using the equity method or those that are consolidated. The unpopular change for banks is that, going forward, changes in fair value will run through earnings. Under current GAAP, equity investments can be classified as available for sale (AFS) with fair values changes running through OCI, or trading with fair value changes running through earnings. This change eliminates the AFS option.

There is good news, however, for equity investments without readily determinable fair values. Banks will have the option to measure these at cost minus impairment, if any, plus or minus changes resulting from qualifying observable price changes. This means investments can be written up with proper observable transactions. The FASB also simplified the impairment assessment by using a qualitative assessment.

Two more changes:

  • Deferred tax assets (DTAs) on AFS securities: Currently there is diversity in practice on evaluating such DTAs separately (given management has control because the securities can be sold) or in combination with other DTAs. The FASB chose the latter.
  • Measurement category: Financial assets and liabilities must be presented by measurement category (such as fair value or amortized cost) and form of financial asset (securities, loans or receivables) on the balance sheet or in the footnotes.

When Is This Effective?

For PBEs, the changes take effect for fiscal years beginning after Dec. 15, 2017, including interim periods within (which means first quarter of 2018 for calendar year-end reporting companies).

For non-PBEs, the changes take effect for fiscal years beginning after Dec. 15, 2018, and interim periods beginning after Dec. 15, 2019 (which means Dec. 31, 2019, for calendar year-ends).

The FASB plans to issue part two of its financial instruments project, a final standard on credit losses, in the first part of 2016 and part three, a proposal on hedging, in the second quarter of 2016.

New Accounting for Credit Impairment and Equity Securities: What You Need to Know

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4-10-15-Crowe.pngSince the financial crisis, the Financial Accounting Standards Board (FASB) has been debating wholesale changes to the U.S. generally accepted accounting principles (GAAP) financial instruments model in two related projects. For the first of the financial instruments projects, the FASB wrapped up in January the bulk of its deliberations on the classification and measurement project and expects to issue a standard in mid-2015. The FASB has come full circle by largely retaining existing GAAP—which means the legal form drives the classification and measurement of financial instruments, namely securities and loans.

However, it will not be business as usual when the new standard goes live for financial institutions. There will be a handful of changes that affect financial institutions, the largest being the requirement for equity securities with readily determinable fair values to be carried at fair value through net income (FV/NI) rather than today’s option to carry them at fair value through other comprehensive income (equity method securities will not be FV/NI).

Of greater interest is the second project: credit impairment. The FASB completed the majority of its deliberations in March and expects to issue a final standard in the third quarter of 2015. This standard, which uses the current expected credit loss (CECL) model, fundamentally will change the way the allowance for credit losses is calculated. The standard will have a pervasive impact on all financial institutions, and questions are circulating about what changes are in store.

What Instruments Are Subject to CECL?
The FASB decided to apply CECL to financial assets measured at amortized cost. For financial institutions, CECL generally will apply not only to loans but also to held-to-maturity debt securities and loan commitments that are not classified at FV/NI.

How Is the Allowance Measured Under CECL?
A current estimate of all contractual cash flows not expected to be collected should be recorded as an allowance. When developing this estimate, institutions also need to consider reasonable and supportable forecasts of the cash flows for the financial asset’s life. Given that CECL effectively is a lifetime estimate, institutions will need to estimate the life of the asset by considering the contractual term adjusted for expected prepayments but not considering renewals or modifications unless the entity expects to execute a troubled debt restructuring (TDR). This new focus on payment speeds outside of an ALM calculation might be a challenge for some financial institutions in terms of both data availability and capability.

The FASB is focusing on making CECL as flexible as possible and is retaining other items that had been incorporated in the incurred loss model. For example, the allowance calculation still includes “relevant quantitative and qualitative factors” based largely on the business environment and similar factors that relate to their borrowers (such as underwriting standards). However, the CECL model is different from today’s incurred loss model because it removes the “probable” threshold and accelerates the recognition of losses.

What Are Some Other Changes?

  • Purchased Credit-Impaired (PCI) Assets. The FASB is changing the definition of PCI and generally is simplifying the PCI model overall to require immediate recognition of changes in expected cash flows.
  • TDRs. At modification, an adjustment will be recorded to the basis rather than as an allowance.
  • Disclosures. The FASB retained the current disclosures with a few additions. For example, the FASB tentatively decided to require credit quality disaggregated by asset class and year of origination (in other words, vintage), subject to staff outreach.

What About Transition?
Once the standard is adopted, there will be a cumulative-effect adjustment to the balance sheet (credit allowance, debit retained earnings). For debt securities with recognized impairment, previous write-downs are not reversed. For PCI assets, an allowance is established with an offset to cost basis.

What Is Next?
At the March 11, 2015, meeting, FASB staff received permission to begin drafting the standard. The FASB will discuss at a future meeting any remaining issues identified during the drafting process, cost-benefit considerations and effective date.

What Does My Financial Institution Need to Do Now?
Top on the list for any financial institution is to begin to think about what data would be necessary to develop better forward-looking estimates of expected cash flows and whether that data currently is being retained.

How the New FASB Standard on Revenue Recognition May Impact Banks

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revenue-maze.jpgThe Financial Accounting Standards Board (FASB) recently released its long-awaited standard addressing revenue recognition. Existing U.S. generally accepted accounting principles (GAAP) were largely developed on a piecemeal basis and are industry- or transactional-focused. Consequently, economically similar transactions sometimes resulted in different revenue recognition. Accounting Standards Update (ASU) 2014-09, “Revenue From Contracts With Customers (Topic 606),” adopts a standardized approach for revenue recognition. This was a joint effort with the International Accounting Standards Board (IASB), resulting in converged guidance under both GAAP and International Financial Reporting Standards (IFRS). Of course, companies will report the same total amount of revenue over time, but the timing of the recognition could be accelerated or delayed when compared with current practices. 

A Core Principle and a Five-Step Approach

The new ASU is based on a core principle: “Recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” To achieve this principle, the guidance spells out several steps that a company must take when determining when to recognize revenue on its financial statements.

  1. Identify the contract with a customer.
  2. Identify the separate performance obligations in the contract.
  3. Determine the transaction price.
  4. Allocate the transaction price to the separate performance obligations.
  5. Recognize revenue when (or as) performance obligations are satisfied.

Is This a Big Deal for Banks? 

The new ASU could be a challenge from two perspectives. First, there are certain industries for which there will be wholesale changes, including the software, telecommunication and real estate industries. For the banking industry, wholesale changes are not expected—largely because much of a bank’s revenue comes from financial instruments (including debt securities, loans and derivatives), and many of those are scoped out. That is not to say that banks won’t be affected, because most will. But for most banks, the effect is not likely to be significant.

Second, the challenge for banks (as well as other industries) will be taking the core principle and accompanying steps and figuring out how the guidance applies. In other words, the five steps provided are not written with a specific industry in mind, so a shift in thinking will be necessary to evaluate how the accounting will change for those transactions that will apply to banks. A few areas of potential application for banks include:

  • Loyalty point programs
  • Asset management fees
  • Credit card interchange fees
  • Deposit account fees

Effective Dates

The boards provided a lengthy implementation time for the new rules, giving companies time to develop and put in place new controls and processes. The ASU is effective for public companies for annual reporting periods (including interim reporting periods within) beginning after Dec. 15, 2016; early implementation is not allowed. For nonpublic companies, the guidance is effective for annual reporting periods beginning after Dec. 15, 2017, and interim and annual reporting periods thereafter. Early adoption is permitted for nonpublic companies with certain caveats.

Help Is on the Way

In addition to establishing a revenue recognition working group to own the guidance, the American Institute of Certified Public Accountants (AICPA) created 16 different industry task forces charged with providing industry-specific guidance. One of those 16 task forces is the depository institutions revenue recognition task force. With the issuance of the standard, the work now can begin.

In addition, the FASB and the IASB are forming a joint transition resource group, which will consist of 15 to 20 specialists representing preparers, auditors, regulators, users, and other stakeholders. Its objective will be to promote effective implementation and transition.

At just more than 700 pages, the new standard is the longest the FASB has ever issued. This was a major undertaking by the boards, and given the girth of the standard and the fact that it is not industry specific, it’s safe to say it’s just going to take time to digest.