Answers to some of the most frequently asked questions about the new accounting standard Current Expected Credit Loss (CECL).
Section 1: CECL Implementation
The What, When and Whys of CECL Implementation
The current expected credit loss (CECL) is a new accounting standard that will change how depository financial institutions of any size will account for expected credit losses. CECL requires financial institutions to record “life of loan” loss estimates at origination or purchase. This will replace the current Incurred Loss (ICL) accounting model.
CECL eliminates the requirement to defer the recognition of credit losses until a loss is probable; consequently, applying this model will result in earlier loss recognition. Federal regulators have indicated that they intend for CECL to apply to all depository institutions, regardless of asset size.
The Current Expected Credit Loss model (CECL) standard, instituted by the Financial Accounting Standards Board, took effect on January 1, 2020 for public financial institutions that are registered with the SEC, and will take effect in January 1, 2023 for all other institutions.
Learn more: FASB Proposed CECL Delay But No Time To Waste (BID Article)
FASB, including various stakeholders, determined that the Incurred Loss standard delays the recognition of credit losses and overstates assets, especially in the last global economic crisis. This standard does not recognize a loss until it is determined that it is both probable and predictable. This process limits the loss estimate to current, objective evidence and ignores future expected events. As a result, incurred loss estimates serve more as a lagging indicator of impairment losses rather than a leading indicator of expected asset performance.
Learn more: Using Extra Time Wisely With FASB’s CECL Delay (BID Article)
The big banks had to implement CECL by January 2020, and we have started to hear some of the results. Most of the big banks have a large percentage of consumer loans and credit cards, which seems to be the primary reason for increased reserves. Bank of America expects its reserve to go up by about 20%, while Capital One believes its reserves will increase overall by about 40%. Meanwhile, Fifth Third Bancorp expects up to a 50% increase in reserves, primarily due to consumer loans and mortgages.
Community financial institutions that mainly hold commercial loans and CRE loans may find their reserves less affected by the CECL standard than these big banks.These types of loans are generally shorter duration and historically lower loss rates, which should dictate lower reserve than consumer loans and credit cards.
Learn More: Big Banks Report on CECL (BID Article)
No, Federal regulators suggest everyone should be looking into CECL now. Rather than waiting until closer to implementation deadlines, PCBB’s recommendation is to begin preparing now by examining various methods and archiving loan-level data. The more time you have to understand the various allowable methods and analyze your data, the more options you may have to select the ideal methods for CECL.
Learn more: Using Extra Time Wisely With FASB’s CECL Delay (BID Article)
Community based financial institutions, which traditionally focus on real estate finance, will need to do additional work with respect to loans that lack highly similar repayment characteristics (CRE and Multifamily versus Single Family). Many times commercial real estate transactions are referred to as deals versus loans which would be an indication that they lack similar repayment characteristics, and thus will need to use component versus loss rate methods.
While some institutions may consider shortening the terms of their loans to minimize some of the repayment complexities of their loans under CECL, rollover risk and default risk could increase with shorter term loans.
Learn more: Loan Maturity and CECL: The Balance Between Rollover Risk and Reserves (White Paper)
Section 2: Impact of CECL
The Impact of CECL for Financial Institutions
CECL requires that financial institutions record "life of loan" loss estimate for unimpaired loans at origination or purchase. This replaces the current "incurred loss" accounting model, and it poses significant compliance and operational challenges.
Financial institutions that hold loans (and securities) with maturities beyond the next year or two will be particularly affected by CECL. Many community banks hold large allocations of assets with longer maturity dates - usually arising from real estate loans. This adds to the complexity of the calculation. For example, since real estate loans have maturities of 10-30 years, and borrowers often want the ability to pay off or refinance these loans early, this prepayment optionality must be included in valuing the loan life.
On-demand Webinar: Where do I Start with CECL? Critical Steps for Success
For real estate loan calculations, financial institutions will need to look at a number of different factors to create an accurate life of loan. Specifically, they will need to use their historic data to determine historical prepayment rates. To properly value optionality embedded in the life of loan, many will need to break them into distinct loan groups to most accurately measure optionality (just like they do when they measure interest rate risk). The challenge facing financial institutions is both gathering and analyzing this data and determining how many similar groups should be modeled and which methods under CECL work best. Additionally, real estate and other loans with balloon payments will likely need to be separately grouped as balloons may alter both prepayment as well as default/loss expectations.
Learn more: The Balance Between Rollover Risk and Reserves (White Paper)
Under the CECL rule, financial institutions must choose from several methods and decide which ones work best for their various loan portfolios. Since many financial institutions have more than one loan type in their portfolio, they will likely need more than one method. In a recent survey PCBB conducted, 63% of financial institutions stated that they expect to use two or more methods.
Since there are a variety of ways to calculate your loss reserves, that can be confusing when attempting to implement this new rule. For example, it is harder to model expected losses, if you have very few losses overall. There simply may not be enough data to feed into the model. That dilemma seems to fall disproportionately on community financial institutions, which tend to be very good at managing loans and credits, so they have few instances of high frequency of loss.
To make it a little easier, PCBB FIT Advisors work with our clients to advise them as much or as little, during CECL implementation, on which method works.
On-Demand Webinar: Choosing the Best Methods for CECL: What’s Right for My Bank?
FASB have stated that the Weighted Average Remaining Maturity (WARM) method could be acceptable for some financial institutions to perform their CECL calculations. This method calculates an annual expected charge-off rate, based on multiple historical periods. It then takes that rate and applies it to the remaining balances of assets in a given group times the WARM. While FASB recently noted that this method could be used for less complex financial asset pools, bankers will need to consider some potential issues if starting down that path.
Learn more: Is WARM Right for CECL? (BID Article)
Q Factors are meant to compensate for adjustments needed due to changes that occur outside the model, including: global economic trends; business conditions; the nature and volume of loan terms or portfolio; concentrations of credit, among others. When working with Q Factors, your institution always has control and makes the final decisions.
On-Demand Webinar: New Expectations for Q Factors with CECL
Financial institutions need to start to prepare for CECL today. The first step is assessing their historical data and determining what data they need and what data they do not need. Organizations also need to get multiple departments involved in the CECL preparation. It can’t be left to one department, individual or piece of software alone. Start collaborating now and the transition will be a smoother one. If you find that first step is a difficult one, we can help.
Learn more: Schedule a Demo of CECL FIT
There will be a substantial amount of work required before implementation. In order to be CECL-compliant by the deadline, the following steps should be completed:
- Inventory available data inputs
- Analyze data (repayment terms, default and loss history, changes in underwriting and grading, etc.)
- Determine workarounds for missing loss history vs. asset life
- Identify similar loan groups and check to see if sufficient information is available to use
- Test each method (do the calculation) to understand data requirements and determine if the method produces meaningful results
- Choose methods for each similar group by its unique characteristics
- Generate results including sensitivity analysis around key assumptions (prepays, migration, rising/falling past-due/non-accrual)
- Determine the financial impact of the method(s) used
- Vet findings with management, board, auditor and examiners
- Run parallel until transition
While the effective date for most community financial institutions is not until January 1, 2023, regulators have begun to ask questions about how well CECL preparation is going.
One source is a government publication:
Modeling is integral to the process of calculating losses under CECL, and regulators want to know the process, the methodologies, assumptions and the thinking around all of this. To help you prepare, PCBB has some possible questions that examiners might ask.
Learn more: CECL Time - What Examiners Will Want To Know (BID Article)
- Credit: CCO and loan operations
- Finance: CFO and controller
- IT: CIO and DBA’s
Section 3: Optimal CECL Approach
The Optimal CECL Approach for Financial Institutions
PCBB provides an integrated, web-based solution to financial institutions, combined with banking experts that will advise as much or as little as you need. PCBB’s solution, CECL FIT ™, provides results for multiple methods, allowing financial institutions to move seamlessly to alternative methods when conditions warrant.
Learn more: View CECL FIT
PCBB provides institutions with the ability to move their data and information to a flexible platform that is independent from the core system. This platform permits the calculation of time series analysis necessary for both loss rate under the multiple methods as well as historical prepayment rates, which are necessary to determine life of asset. Additionally, this platform supports other complex analyses needed for both qualitative factors and the Forward Look.
Learn more: Q Factors Matter More for CECL (BID Article)
Yes. PCBB has a Statement of Controls (SOC) for our existing data center and has an additional SOC for our proprietary applications, of which CECL is included. These address the controls for all of our production environments, including access and data.
As financial institutions prepare to be CECL-compliant, they will need to navigate through the process of inventorying and collecting the appropriate data.
- analyzing the information to determine proper portfolio segmentations;
- testing various CECL methods to determine which methods best match each portfolio’s segmentation;
- generating results and determining financial impact, if any;
- vetting findings with management, the board, our auditor, and examiners, along with creating comprehensive documentation.
PCBB’s advisory team of financial service professionals works with institutions to help them through these processes to determine the optimal roadmap for CECL implementation.
Learn more: Getting CECL Started: Data Inventory and Analysis (White Paper)
PCBB’s CECL solution is the only offering to run all methods simply:
- Closed pool
- Vintage analysis
- Average charge-off
- Probability of default (PD)
- Discounted cash flow
- Regression analysis
This allows financial organizations, with PCBB’s assistance, to mix and match these different methods for various portfolio segments to determine the optimal result. Additionally, this flexibility permits a seamless transition from one method to another, as economic conditions warrant.
Learn more: CECL FIT in Action
Yes. CECL FIT accommodates Held to Maturity Securities (HTM Securities). They can be grouped and assigned a loss rating, as well as generate an expected credit loss value for the period.
Yes. Each institution is unique. So, PCBB created three tiers of CECL FIT to best meet your institution’s specific portfolio needs and budget. Each or our options provides a balanced range of services, depending on the requirements you need. If you need a single method and want to upload the data yourself, we have the solution for you. Or maybe you are looking for the flexibility of several methods and would like more assistance along the way—we have the solution for you too.
Learn more: 3 Tiers of CECL FIT to Meet Your Needs