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Economic forecasting is a major facet and discussion point of the quickly approaching current expected credit loss (CECL) model. Financial institutions will not only have to report incurred losses on their books, but they will also need to project their loss estimates over the entire life of the loan at origination. This may seem like bankers have to get good at accomplishing the impossible task of “predicting the future,” or estimating their future loan collectibility, which can pose challenges for financial institutions due to the unpredictability associated with envisioning upcoming circumstances.
The standard explicitly states that “An entity shall not rely solely on past events to estimate expected credit losses. When an entity uses historical loss information, it shall consider the need to adjust historical information to reflect the extent to which management expects current conditions and reasonable and supportable forecasts to differ from the conditions that existed for the period over which historical information was evaluated.”
There has been uncertainty in the financial industry about how to conduct forecasts. In an informal poll during a CECL group demonstration of 60 employees from both banks and credit unions, 25 percent of respondents anticipated that determining a reasonable and supportable forecast will be the largest challenge related to CECL at their institution.
Additionally, the American Institute of Certified Public Accountants (AICPA) Financial Reporting Executive Committee, known as FinREC, recently submitted a working draft of an issue paper on the CECL standard in an attempt to clarify potential issues associated with forecasting under CECL, as they view it as a potential roadblock for implementation. A few of the issues they hope to resolve are considerations when making a “reasonable and supportable” forecast and how to determine the appropriate historical loss information for the reversion period. The draft will have an open comment period until Dec. 31.
Bankers who wonder how far into the future they must estimate future credit losses under the updated standard should look to the contractual terms of the asset. Sageworks Executive Risk Management Consultant Tim McPeak notes, however, that the contractual terms only provide one piece of the answer to the question, “How far is far enough?” Institutions will need to factor in their expectations for prepayment and refinancing behavior in their view of the life of the loan under the updated standard, which goes into effect first for SEC-registered financial institutions in 2020.
Although FASB’s requirement of estimating forecasts may seem intimidating, there is an emphasis on the word estimate. It is recommended that management use their best judgment when predicting future losses, whether the information comes from internal information, external information or a combination of sources. The standard supports this by stating, “When financial assets are evaluated on a collective or individual basis, an entity is not required to search all possible information that is not reasonably available without undue cost and effort.” No specific method for measuring credit losses was specified in the standard, and internal information may be enough.
In an upcoming webinar, McPeak will make recommendations for both economic forecasting and qualitative adjustments under CECL. Attendees of the webinar will learn different approaches to applying forecasts within CECL calculations and how to properly source and document forecasting decisions that are made. This session is will be worth 1 CPE credit.
For more information, register for the upcoming webinar, Subjective CECL: Qualitative Adjustments and Forecasts Under the CECL Model.
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