Key Considerations Tied to the Pandemic and CECL, Allowance-Related Issues

Paula S. King, CPA
June 1, 2020
Read Time: min

The last three months have brought Chief Financial Officers at community financial institutions an influx of new considerations, work responsibilities, and challenges. As if CFOs didn’t have enough to focus on already with reporting tied to financials, asset/liability management, strategic planning, and enhancing the bottom line, the pandemic stormed in as 2020 was off to a solid start. No one would have guessed that after the longest economic expansion in U.S. history, we would experience a health crisis that has affected our lives and economy so quickly and dramatically. Along with this has come the SBA’s Paycheck Protection Program with all its nuances and requirements of financial institutions, which has brought new and different concerns to bank CFOs as they support local businesses throughout this uncertain time.

Given the many competing priorities, CECL, the long-awaited current expected credit loss Update, has likely taken a back seat at many institutions. However, given that the actual effective date for CECL has not been delayed, CFOs of SEC-registered banks that had implemented CECL on Jan. 1 must remain mindful of the pandemic’s impact. Even banks that remain on the incurred-loss model and have a 2023 deadline should not lose sight of CECL. With 2020 disrupted by the PPP and other efforts to help small business customers stay afloat, a bank’s previous timeline for assessing data gaps and taking other steps to be prepared by 2023 could face serious delays without a concerted effort to get back on track.

CFOs have numerous considerations related to the impact of the pandemic on the allowance, whether it is calculated under the incurred-loss model or CECL. Here are a few related to CECL implementation, loan modifications, and qualitative or forecast components.

CECL delay and updates

The CECL effective date is not delayed, nor have effective dates for CECL adoption been changed. Rather, financial institutions that adopted CECL as of Q1 2020 have an option to delay the presentation of the impact of CECL on their financial statements. The CARES Act in March allowed the presentation delay until the earlier of the end of the pandemic (yet to be defined) or Dec. 31.

Financial institutions will need to continue to run their CECL calculations throughout 2020 in order to determine the impact and retroactive adjustments necessary. Banks will need to restate the allowance for the periods from Q1 2020 up to the end of the delay.

For banks calculating the allowance for loan and lease losses (ALLL), 2023 remains the deadline, despite calls for additional CECL implementation delays. Administratively, CFOs will need to balance their time between handling the pandemic-related issues of 2020 and staying on track with institutional goals for completing data analysis, selecting methodologies, validating models, and making adjustments over the next 31 months.

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Loan modifications and workouts

For lenders reporting under both the expected-loss and incurred-loss models, an increase in loan workouts or modifications may wind up as unwanted impacts on the allowance. With the pandemic, the PPP, and deferments of P&I payments for three months, six months and some longer, workouts will loom on the horizon over the next couple of years. It is inevitable given the impact of the pandemic. Consider the number of business closures in your service area, the designation of essential and non-essential businesses, the slow pace of business re-openings, and the variations in re-opening timelines by state, depending on the stage of the pandemic.

These workouts may be large and more than we have seen in recent years, considering that workouts have been minimal or isolated to specific borrower circumstances.

It will be necessary for credit professionals to gear up their workout area and dust off their policies and procedures, but how will these workouts impact the allowance? The impact will be felt in an increase in troubled debt restructurings (TDRs) – nonperforming at first until a track record of payments is achieved, but still a TDR, nonetheless. This will require an analysis of the concessions granted in the modification agreement and most likely, a discounted cash flow analysis, due to the concessions, to determine the value of the loan. If similar concessions are granted pursuant to a loan modification program for certain types of loans, alternatively, these loans may be pooled with a reserve calculated at the pool-level. Keep in mind that the concessions would typically need to be part of an overall program for these loans that are selected for pooling.

A caveat to this normal treatment is that because of the pandemic, regulators and the FASB have agreed that short-term loan modifications tied to the pandemic do not have to immediately count as troubled-debt restructurings. That creates another layer of complexity in determining TDRs.

Qualitative and forecast components

Less than four months ago, financial institutions were experiencing minimal losses and problem loan trends, and strong economies, so, in theory, their qualitative adjustments, at least for problem loan trends and the economy should have been minimal. Certainly, both current qualitative as well as forecast conditions will require significant adjustments to reflect the deteriorating economic conditions seen over the last few months and, no doubt, likely to continue through the remainder of 2020 and, perhaps, beyond. Banks will likely experience the impact of deteriorating conditions (problem loans) longer than originally predicted in early 2020, so it will be important to consider the longer horizon for the forecasting component in ACL calculations.

With CECL’s life-of-loan concept, the adjustment will be more significant than under the current incurred loss model. This will need to be recognized when adjusting for current and forecasted conditions that are not reflected in quantitative models. Historical models would not support any current conditions and those likely to be experienced, unless the institution has data back to the Great Recession and was negatively impacted by it. The Great Recession resulted from a financial crisis. What is so different about the current crisis is the uncertainty of the end or at least the turning point of a health pandemic that we have not seen in our generation’s time. Until major economic indices, such as unemployment, improve, the CFO will need to reserve for risk associated with current economic conditions as well as risk related to the economists’ forecasts of pertinent indices.

Given deferments, institutions are not currently experiencing stress in their loan portfolios (e.g., non-accruals, significant past-dues). However, as months go by, the CFO should be prepared to make changes to qualitative adjustments and forecasts to accurately reflect conditions and future risks, such as delayed business openings or low consumer support, stress in oil prices and other segments, and industry stresses such as hospitality as well as deferments ending. While counterintuitive, the CFO may want to extend the institution’s forecast horizon, primarily because the loan portfolio may not be impacted until later and this impact will be protracted as deferments and government support programs end.

About the Author

Paula S. King, CPA

Paula has held executive positions, including as Chief Financial Officer, in the banking industry for more than 25 years. As a former CFO, Paula has extensive experience in the design, preparation and reporting of the allowance for loan and lease losses, including ensuring compliance with regulatory and audit requirements, and creating allowance policies, procedures and processes. In addition, she has worked with loan operations and lending staffs and utilized the capabilities of a variety of core systems to ensure appropriate loan coding for optimal loan portfolio segmentation. Paula has been responsible for SEC and financial reporting, capital raising efforts and strategic planning, and has served as a Chief Risk and Compliance Officer. She has been responsible for overseeing daily operations for several banks and frequently served on internal credit committees. She co-founded a bank and served on its board of directors through its merger with another financial institution and has been a de novo bank consultant to boards and senior management teams.

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