Can a Credit Union’s Allowance Be Lower Under CECL?

The central tenet of the current expected credit loss model (CECL) is the requirement that financial institutions account for expected losses over the entire life of the loan and do so up front, rather than on the current, incurred basis. It is for this reason that many observers have speculated that allowances for loan and leases losses could, in general, be higher under the new accounting standard.

However, loan loss reserves in the second quarter were 1.22% of total loans among all U.S. banks, according to FFIEC data on the Federal Reserve Economic Data website, a continuation of a downward trend from the peak of 3.7% in 2010. If favorable economic conditions persist, allowances – even under the new CECL model – could be relatively stable or perhaps even lower, which has some bankers worried about how examiners would react.

Indeed, during a recent webinar hosted by federal banking agencies about the new accounting standard, one of the questions posed was whether examiners would challenge institutions if their method results in a lower allowance under CECL than under the incurred loss model.

Robert Storch, chief accountant for the Federal Deposit Insurance Corp.’s Division of Risk Management Supervision, responded that institutions “should be prepared to offer documentation and support” if the overall allowance is lower when an institution first adopts CECL than the overall allowance that had existed under the incurred loss methodology immediately before adoption.

“More broadly and on an ongoing basis, your examiner would challenge your institution if your allowance level is unreasonably low if your examiner’s review of your CECL estimation process indicates that the inputs into your allowance estimate, including the historical loss information and management’s forecasts, assumptions and judgments do not appear reasonable and are not properly supported,” Storch said.

In other words, credit unions should be prepared to document and support why their allowance levels are what they are.

“This topic is speaking to some of the key questions bankers have had about CECL, really, since the FASB began working on it,” Tim McPeak, executive risk management consultant for Sageworks, said. “Some have wondered if [the CECL model] is just a mechanism to dictate higher reserve levels overall. Some have been asking, ‘Does my number have to go up?’ This is understandable, because the reserve today is essentially an annualized number – it’s one year’s worth of numbers on losses, and if you move from one year to the losses over the lifetime of the loans, it seems intuitive that the number would go up. But the regulators have been pretty consistent, and this response is in line with what we’ve heard them say before.”

Credit unions have also wondered how examiners will evaluate the adequacy of allowances under CECL. But during the webcast, Storch reiterated previous guidance from regulators that agencies aren’t setting targets or ranges for institutions.

“Because allowance levels depend on institution specific factors, the agencies will not establish benchmark targets or ranges upon adoption of CECL or going forward,” he said during the webcast. “The agencies’ objective is not to drive institutions to maintain allowance levels that approximate the peer group median but to maintain allowances that are appropriate for their specific portfolios under CECL.”

Storch said institutions’ CECL allowances should:

• Have support and documentation;
• Be “reasonable and supportable”;
• Make sense for the institution, taking into consideration the institution’s risk appetite, underwriting standards, the quality of its loans and performance, and other characteristics of its portfolio; and
• Be based on an institution-specific analysis of the loans in its portfolio and the other assets and exposures within the scope of CECL.

McPeak said regulators have been saying for years that they will not have benchmarks for allowance levels or direct institutions toward where allowances need to be. However, McPeak noted, all of the discussions during the webcast reinforce the idea that if allowances are flat or lower, regulators will want a close look and will want to see a lot of supporting documentation, particularly for allowances that are heavy on qualitative adjustments. “They’re basically going to want to make sure you’re putting all of the ingredients into the cake,” he said. “Do you have a forecast? Where did you get it? They want to make sure you’re not blowing off some part of the standard.”

Credit unions with lower allowances under CECL will likely need to be able to show regulators in some form what they were doing before CECL and why under the new standard the allowance is lower, McPeak said. “Show the path of how you get from Point A to Point B,” he recommended. “These issues in my opinion are very much the heart of what people are thinking about and talking about as it relates to CECL these days. And part of this is that it’s the natural progression as we continue to move from the theoretical to the practical as we begin to implement this. It means we’re getting closer to implementation, whether we like it or not.”

Mary Ellen Biery is a Research Specialist for Sageworks. She can be reached at 984-242-2578 or maryellen.biery@sageworks.com.