Before the end of 2015, the Financial Accounting Standards Board is expected to issue its final standard on the Current Expected Credit Losses model.
Over the past few years, much discussion has taken place over the proposed changes associated with the CECL model and the transition from an incurred loss approach to a lifetime expected loss estimate. Even though the exact effective date is unknown, the impact on your financial institution will be widespread, and the biggest change occurs with your reporting and disclosures.
While you will not face any deadlines in 2015, the time is now to prepare your financial institution for this final standard. Here is how you can get ready and what you need to consider when the FASB implements its update:
Where will CECL affect your institution?
The first place to start is with an overview of your financial institution and the areas that will be most affected by the new CECL model. The key asset scrutinized by the FASB and the CECL will be assets measured at amortized cost.
Naturally, these include loans, but the FASB has broadened the scope of CECL to cover held-to-maturity debt securities as well. This is something that some experts disagree with, including the American Bankers Association. The ABA believes that the CECL is not an improvement over accounting methods currently in place for debt securities.
Even so, loans and certain debt securities are expected to be included in the final CECL model. This is in addition to other assets, such as:
- Non-fair-value loan commitments
- Select financial guarantee contracts
- Reinsurance receivables
- Lease receivables
CECL will also affect your institution’s individual departments. CECL is contingent on understanding future credit losses and more in-depth and accurate long-range forecasting. CECL could pose a legitimate concern for an institution that has either poor or no communication and data-sharing between departments. Its final standard may be the impetus behind widespread change in your institution regarding interdepartmental communication.
A proactive approach will help your bank prepare for CECL.
How can you be prepared?
The effective date for the new CECL model is expected to be a few years away. Even so, now is the perfect time to prepare your institution for the coming changes.
To begin, you can break down your preparations into three steps:
Step 1
The first step is a broad approach. More data is going to be required due to CECL, and this will in turn require more information and detailed accounting from your institution. Begin by gathering information. Analyze:
- Factors expected to drive credit loss
- Expected life of a financial asset
- Relevant internal and external data related to financial assets
- Probability of loss
The FASB wants all institutions to reflect the risk of loss in their predictions. Where your past estimates may not have found any risk – or identified a highly unlikely chance of loss – the new, more in-depth accounting standard might produce other results.
“Start talking with experts today.”
The more information you have, the better off you’ll be. Now is also the time to begin conversations with auditors, CPAs, consultants and regulators.
Step 2
The second step is to actively adjust your current systems and methodologies to provide more actionable data for your institution. The FASB announced that it will not limit the number of strategies used to estimate expected credit losses.
You can use several, including:
- Discounted cash flow analysis
- Vintage analysis
- Roll-rate method
- Collateral-dependent method
- Probability of default method
- Regression analysis
However, it is important to keep in mind that the new CECL model may impact certain methodologies. For example, the collateral-dependent method could change due to a redefined version of “collateral-dependent,” according to the FASB. Any new definition would alter the viability of strategies for your institution.
On a similar note, other methodologies may change as well. Discounted cash flow analysis will shift due to the removal of the best estimate and the new requirement to account for at least some level of risk.
The CECL could also reduce the effectiveness of the roll-rate method as well. Roll-rate methods built off of risk ratings need constant and consistent updates to credit risk, which can hamper the predictive capabilities of this methodology. These are just a few examples of how CECL will impact your potential forecasting strategies.
Overall, you must have systems in place that disseminate as much data as possible throughout your institution in order to gain a clear picture of loss risk, as well as analyze the impact CECL will have on traditional methodologies.
Step 3
The third step is to upgrade your existing forecast models. Once you have data, you can turn that information into more accurate forecasts of lifetime expected loss of your financial assets. The new CECL model will require more supportable predictions using data gleaned from inside and outside your institution.
With in-depth information, you will have an easier time revising existing forecast models and creating new models using more supportable internal and external data. Work on improving your institution’s predictive capabilities now, before you are required to do so by the FASB.
“Don’t just gather data – use it to your advantage.”
What will you have to keep in mind?
Building a veritable warehouse of data is a strong foundation for the new CECL model, but it isn’t the only solution your financial institution will require.
For instance, you will need to use that data effectively in order to remain prepared and simplify the implementation of the CECL final standard. You will also need to combine your risk management and your accounting practices. These departments have to work together for your institution to avoid problems with CECL. The model does not have to be a negative for banks. On the contrary, it can serve as the impetus behind a change to a more efficient, effective and profitable banking system.
Above all else, keep in mind the benefits of an automated system. If you still have manual processes in place for gathering data and analyzing asset risk, now is when you want to replace those systems with automation. This will help you evolve to the final standard and save money in the long run.
As the announcement of the new CECL model from the FASB draws closer, the Clark Schaefer Hackett team remains ready to assist you with all your financial and risk management needs. Contact us today to learn more about how you can implement the new standard.
