How Lenders Are Addressing CECL Requirements

The current economic expansion since the Great Recession of 2008 and 2009 has been extremely robust across a variety of industries.

In fact, September 2018 marked the 10-year anniversary of when the American economy saw its deepest, darkest moments of the Great Recession, when the United States witnessed the meltdown of financial markets leading to the loss of millions of jobs and homes. Since then, the country has added jobs every month for almost eight years, and the bull market that began in 2009 is now the longest in history and continues today.

The automotive industry was a leading reason why America was able to pull itself out of the recessionary period and has been among the hottest industries over the past 10 years. In fact, two of the years since the recession saw the auto industry break all-time sales records, with 17.46 million cars sold in 2016 and 17.39 million sold in 2015.

Economic cycles come and go, and this may be part of the reason why the Financial Accounting Standards Board has instituted its new Current Expected Credit Loss model.

What Is CECL?

CECL may require higher levels of capital to be kept in reserve and will likely lead to changes in lending practices and portfolio and product management. It will also likely require a significant amount of work to meet the implementation deadline of Dec. 15, 2019. A key accounting change from CECL is that lenders must now set aside reserves for future losses based on the life of the loan.

Currently, lenders are likely doing short-term forecasts for their loan loss reserves. However, when the economy starts changing, it may impact how those short-term forecasts perform.

Why CECL Was Implemented

The incurred loss approach works well in a steady environment where loss rates are relatively stable. Loss reserve levels will increase and decrease along with the business cycle, but will remain within a relatively tight range as long as lending standards don’t loosen appreciably and the economy does not collapse. However, by waiting for trouble to be revealed, lenders may need to scramble to raise capital in the face of rising losses. Bank shareholders may learn about the riskiness of the loan portfolio only after delinquency rates start rising; by then it would be too late to demand changes to lending practices.

This behavior is exactly what prompted the Great Recession, when loan loss ratios hit a record low in 2006 before skyrocketing to record highs within a few short years. This volatility and the delayed provision of information to investors were the key motivations for FASB to change the loss accounting rules in favor of a more forward-looking procedure.

Beyond simply complying with CECL, lenders have a clear opportunity to turn it into a competitive advantage. Those institutions that best implement CECL will have greater retained earnings and lending capital than their competition. Financial institutions that harness analytic models that can be executed at speed will have better control of their lending capital than their competitors, and be able to grow business faster and minimize losses better while remaining in compliance.

The Role Data and Analytics Will Play in CECL

At the heart of CECL is new regulation that may require significant changes to the data a bank maintains and analyzes, and involves a much deeper level of modeling, analysis and reporting than what has previously been required. Lenders at the forefront of the industry will leverage data and analytics to help support new CECL standards with respect to consumers, and accurately forecast their reserves based on this new modeling standard.

While economic cycles spur new rules and regulations from the government, lenders will continue to see new forms of requirements that help protect the best interest of the institutions, their customers and members, and the overall economic engine. Through the use of data and analytical modeling, financial institutions can better protect themselves from losses and minimize risk, while remaining ultra-competitive in an environment that continues to place more pressure on the bottom line.

Lou Loquasto is Auto Finance and Dealer Leader at Equifax Automotive Services. He can be reached at 888-202-4025.