It’s Real This Time — Really
Since the end of the financial crisis, the Financial Accounting Standards Board (FASB) has been working on a new standard to change the way that banks calculate provisions for loan losses.
A new Current Expected Credit Loss (or CECL) standard was first introduced by FASB in 2010. Since then, the CECL standard has undergone numerous changes and amendments — leaving many community banks wondering when and if a final standard would ever be released.
CECL Standard Finally Approved
In April, FASB finally gave final approval to the latest CECL standard. This came after FASB received more than 3,300 CECL-related comment letters and held approximately 120 meetings to discuss the standard. The CECL implementation dates, which have been delayed by one year to give banks more time to prepare for the changes, are as follows:
- Companies that file with the Securities and Exchange Commission (SEC) must implement CECL in 2020.
- Public business entities that don’t file with the SEC must implement CECL in 2021.
- Private and non-profit companies must apply CECL to their annual reports in 2021 and to their quarterly filings in 2022.
FASB Board members are reviewing a ballot draft to make sure that the final standard reflects all of the amendments that have been made to it over the past six years. FASB has indicated it plans to release a final, official version of the standard sometime over the summer.
Also, FASB has said that it will continue to engage in extensive “post-issuance activity” between now and the implementation dates. In particular, its Transition Resource Group — which was created early this year to help smooth implementation of the standard — will continue meeting.
It’s not an exaggeration to say that CECL is one of the most significant changes ever to bank accounting. It will radically change how banks calculate their loan loss provisions, which most experts believe will require them to significantly increase their Allowance for Loan and Lease Losses (ALLL). Additions to ALLL are recorded as expenses, which reduces bank capital.
Currently, banks estimate future loan losses based on losses that have already been incurred — on either individual loans or pools of homogenous loans based on historical experience. Additions to the ALLL are permitted only after the occurrence of adverse events makes it probable that losses have already occurred.
CECL will require lenders to estimate expected losses over the lifetime of loans at the time when loans are booked. The standard will require banks to switch from using an incurred loss model to using an expected loss model when projecting future loan losses.
It has been estimated that CECL will result in a one-time ALLL reserve increase by banks of between 75 percent and 100 percent. This would translate to a $50 billion to $75 billion cumulative impact on the industry. Keep in mind that this will be a one-time charge to beginning retained earnings (not an expense) in order to bring ALLL reserves into conformance with CECL that will impact regulatory capital.
After the initial charge, banks will make provisions for expected losses on new loans, net of loans paid off and adjusted for changes in the risk profile of the new loans.
How Feasible is CECL?
Since the concepts behind CECL were first introduced nearly a decade ago, banks have questioned the feasibility of forecasting future credit losses. The vast majority of comment letters FASB received regarding CECL were critical of the standard.
Community banks in particular have voiced concerns about their ability to gather and process the data that will be required to conform with CECL. Few if any community banks currently have the systems or expertise in place that will be needed to collect and analyze this data.
Also, CECL is will significantly reduce Tier 1 capital and probably increase volatility in banks’ earnings and P&Ls. With community banks under pressure to build their capital base and grow their loan portfolios, anything that reduces capital will be harmful.
A Competitive Disadvantage?
Most experts agree that CECL will have a big impact on the costs incurred by banks of preparing and auditing the ALLL, as well as how investors analyze the ALLL and how banks manage Tier 1 capital. Also, higher and more volatile levels of ALLL may restrict bank lending — which could affect not just banks but small businesses and the broad U.S. economy as well.
The biggest concern among most community banks is that they could be put at a competitive disadvantage if they can’t implement the CECL model cost effectively. Here’s why:
Complex modeling (like discounted cash flow) could result in lower and/or less volatile ALLL levels earlier in the life of a loan than less complex models (like the use of loss rate methods). However, the vast majority of community banks do not have the experience or expertise to utilize such complex modeling cost effectively.
What To Do Now
The implementation dates for CECL may be 2020 and beyond, but now is the time to devise a CECL implementation plan for your bank.
Start by determining how you will collect and analyze the data you’ll need to conform with CECL. Talk to vendors who are building software programs to help community banks with CECL implementation. Also put in place a framework to rewrite your loan policy, including your methodology, portfolio segmentation, and frequency and approval of ALLL testing.
Don’t be lulled into complacency just because CECL’s implementation dates are still several years away. Start working on your bank’s CECL implementation plan now so you’ll be prepared when CECL becomes a reality.
Give us a call if you have more questions about CECL and how it could affect your bank. We’d be glad to discuss this with you in more detail.
A CECL Q&A
In January, the American Bankers Association published a Backgrounder on CECL that included the answers to some common CECL questions community bankers are asking, such as:
Q: What’s at stake with the accounting change?
A: Banking regulators have referred to CECL as “the biggest change ever to bank accounting.” CECL requires significant changes to the data and information a bank maintains and analyzes.
Q: Why is CECL so different from what the accounting is now?
Current accounting is on an “incurred loss” basis, meaning that an event has occurred that will cause a loan to go bad. In contrast, CECL is on an “expected loss” basis, meaning that an event is expected to occur in the future that will cause a loan to go bad.
Q: Will CECL prevent or diminish future financial crises?
A: CECL is not written for bankers to forecast future financial crises. Although the process that has resulted in CECL was initially precipitated by the Financial Crisis Advisory Group (FCAG), less volatile (and, thus, less procyclical) bank earnings is not an objective of CECL.