Since 2012, FASB has been working on a 'new and improved' approach to calculations of allowance for loan and lease losses (ALLL), and in fact the group's discussions about loss accounting date back as far as 2005.
1 On June 16
th, FASB issued the new standard, ASU 2016-13, which is the result of at least four years of effort, discussions and negotiations with individuals, trade groups and other interested parties. And now we officially have another acronym to add to the alphabet soup of banking rules and regulations - CECL, short for Current Expected Credit Loss, as part of
Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.
We have some time to get used to this one, since the new accounting rule does not get implemented in financial reporting until December 15, 2018 for the earliest of early adopters. Behind the scenes, the pre-work has already been happening as bankers have begun digging into the data requirements that will accompany this new technique for reporting loss dollars. The pre-work will now pick up in pace, as the reality is that this is a
big shift and as some have commented, this is the biggest accounting change banks have ever faced.
2
Who can argue that a change was needed? By its very nature the existing approach to calculating reserve levels is backward looking, and will not allow sufficient preparation for a downturn even close to what the economy experienced in the 2006 - 2009 period. As the economy has recovered since 2010, banks that survived have 'enjoyed' the recapture of reserves financially, but sometimes with reservations, knowing that the pain of recreating them was just another economic cycle away. That cycle is already underway, as loan growth has been ramping up with many of the same red flags we had just lived through reappearing - so what can be done to stop the roller coaster? CECL may be a hand-brake of sorts. And keep in mind that the banking industry is not the only group impacted by this FASB rule. Any entity that carries debt or securities at cost would have to address this new approach to reserves in their financial reporting, so this will impact many industries, including leasing companies, captive finance companies, etc. From an investor standpoint, a lot of frustration regarding true expectations from assets will be reduced, if not eliminated.
3
The initial hit to financials at implementation will be the biggest change and hopefully a 'one time' event that is industry-wide, so the markets are not driven to over-react. As compared to current ALLL reserve levels, the expectation is that the increase will be 30-50%, a level projected by an OCC study back in 2013 and echoed by others since.
4 New reserve levels will be based on a 'Day 1 loss' assessment, and will use a 'life of loan' (LOL) loss estimate. (Yes, this is another acronym, and the humor element of a new meaning for 'LOL' should be a bright spot in an otherwise dreary discussion.)
There is simplification that comes with the implementation of this new approach, and while some will argue that there is subjectivity in the new rule, there was similar issue with the prior approach. The calculations of 'impairment' are removed from the routines, as CECL uses a 'single measurement approach' which is applied to all assets. While the final ASU document is over 250 pages, many of those pages are actually presenting paragraph after paragraph of omitted language that directed calculations of impairment which were required under the prior approach to ALLL. These pages are a pleasant surprise to anyone tasked with reading the complete rule document.
5 Truly the topic of impairment consumed so many man-hours and so much discussion time on its own that the impact of this new effort may be on balance a wash, if things go well.
CECL implementation
has to be a cross-functional effort by bank management. Finance will be of course involved - among other things, this is at the end of the day an accounting entry. Risk management and credit will have to play a role in analyzing the inputs and the resulting data, and IT and operations will have to create systems and inputs that capture the data points needed to complete the necessary analysis. Data integrity will get new focus as there will be a direct impact on the banks financial performance as a result of calculations made with multiple years of note level data. The team at each bank will need to create a process that works for them, and that will stand up to scrutiny and provide logical documentation based on factual analysis, and where needed logical forward looking assumptions. The use of existing technology and implementation of new solutions will make the IT team a critical player in solving the challenges of data collection as well as data integrity, and then that technology can assure consistent application of the approach to the data to some degree. Each organization will need to identify the 'loan pools' appropriate within its own portfolio, as the assignments of loss will happen at the loan pool level with CECL, where the prior ALLL results were based on note level determinations. Once these decisions are made, the methodology should be applied consistently and re-evaluated as part of an ongoing process within each organization, as results over time can be then compared to actual experience and modified accordingly.
At the end of the transition period, the new CECL era may truly be what the 'prudent man' would deem a valid step to taming the cycle of performance in the banking industry. Regulators have been unable to drive that effort alone, but with the accounting industry stepping in, there may be a real long term improvement in stability. And we have to at least try, because no one could argue that the 'old way' was working.
