With the Financial Accounting Standards Board announcing another delay in the release of its final guidance on the Current Expected Credit Loss model, it may be tempting to put the changing guidance and effect it will have on allowance levels in the back of your mind. And you wouldn't necessarily be wrong. The CECL guidance is impactful, certainly, but it's not cause for panic, and this additional delay in the finalized guidance only underscores that point.
However, delay or no delay, the final accounting standard is coming down the pipeline eventually. And it's rare to see regulatory changes with such a direct effect on the allowance in the way CECL is expected to. Regardless of when the proposal is finalized, there is a clear benefit to thinking proactively today about how the CECL guidance might affect your credit union and your credit union's allowance for loan and lease losses calculation.
Currently, institutions calculate the ALLL based on well-established accounting and regulatory standards that have had only minor changes and updates over the past several years. While the exact CECL requirements have not been finalized, CECL will fundamentally change the loan loss reserve calculation and likely have implications across day-to-day operations for the credit department.
So why exactly are the standards being changed? A criticism of the existing “incurred loss” ALLL standards is that they are backward-looking in that they rely primarily on historical information. Currently, institutions recognize credit losses only once they are considered “probable” and the losses can be estimated (primarily utilizing past loss experience). This creates a “lag” in how losses are reflected in the ALLL calculation. This issue was exposed during the financial crisis, as this delay in loss recognition meant reserves were insufficient to cover institutions' growing losses as credit deterioration accelerated. The proposed CECL model suggests forward-looking analysis and looks at the life of the loan, instead of a single year. The objective is that institutions would account for and therefore reserve for losses based on “possible” estimates, no longer just “probable” ones.
What's not made explicitly clear in the initial CECL guidance is how exactly life-of-loan losses can be defensibly predicted using historical and qualitative factors. For many credit unions, particularly smaller institutions, historical loss and loan data may not have been archived or might be inaccessible when it's needed for a CECL calculation.
Another perceived pain point for credit unions is the possible increase to loan loss reserves that might occur under CECL. It's important to note that, since the model isn't finalized, an increase in allowance levels isn't guaranteed to occur. However, in the latest of a series of polls conducted by Sageworks, we've found that more banking and credit union professionals than ever before are expecting a 10 to 50% increase in their institution's ALLL.
As mentioned, FASB was expected to release the final standards this year, but they've updated that timeframe to the first quarter of next year. Assuming that timeframe holds, we'd expect to see an implementation timeline of three to four years after the accounting standards are finalized, depending on the individual institution as well as the governance and policy issued by the NCUA. Again, this is not something to panic about, and an important point to communicate to a credit union's leadership is exact requirements are still unknown.
However, there are certainly things that your credit union can do now to prepare and get ahead of the curve. The best way to prepare for CECL is to proactively gather loan-level data for the portfolio. This would entail collecting and storing data such as a loan balance, segmentation for the loan, risk rating, charge-offs and recoveries associated with the loan (partial and full), as well as loan duration. Building up this historical archive of detailed data will give credit unions the flexibility and resources necessary to adjust their models and use data that's representative of their own institution.
There's little doubt that back-end processes for credit unions' ALLL calculations will change over the next several years. The right steps now are communicating the expected changes and timeframes to the credit union's leadership and beginning to prepare data and management information systems to accommodate the changes.
Tim McPeak is an executive risk management consultant for Sageworks. He can be reached at 919-851-7474 or [email protected].
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