3 Do’s and 4 Don’ts Ahead of CECL
**The FASB issued the final CECL standard on June 16, 2016. For up-to-date information and resources, access the updated CECL Prep Kit.
Banking industry experts expect the FASB’s long-discussed move to the Current Expected Credit Loss (CECL) model will be finalized by the end of the year, but many bank and credit union professionals may be finding that, as Tom Petty once sang, “The waiting is the hardest part.”
Waiting for clarity on the final standard is difficult, because financial institutions are anxious to determine how the transition from an incurred-loss model will affect the allowance for loan and lease losses (ALLL), and consequently, capital requirements, according to Walter McNairy, managing partner of DHG Financial Services, a national practice of Dixon Hughes Goodman LLP.
“What is the impact to the bank? That is the primary concern for the financial institution,” he said in a recent interview. “Will I still be in compliance with capital ratios? And given that Basel III is out and effective, will I be in compliance with fully phased-in Basel III capital ratios?”
In addition, institutions – especially community banks — have operational concerns, McNairy added.
“Do I have the data, the systems and the horsepower to be able to go and finely tune my allowance to capture all of this information, to give me a better estimate of my total life-of-loan losses?” Financial institutions are used to having quarterly charge-offs, he said. They are not typically tracking charge-offs by the loan’s “vintage,” yet gathering that type of information is going to be critical to estimating the allowance under CECL.
As financial institutions await the final details, McNairy says they should be proactive on several fronts, taking steps to prepare for the new CECL model. He also has some cautionary advice for banks and credit unions as they consider taking action ahead of the final version of CECL.
Here are three do’s, or recommendations, and four don’ts, or pitfalls, for financial institutions to consider:
1. Understand the new CECL requirements. “Take time to read the proposal from the FASB,” McNairy said. Especially once the final standard comes out, he said, someone in the institution should take ownership and read through the document, as opposed to just reading or hearing ‘soundbites’ from others in the institution, from accounting firms like his, from media or from other outside sources. “Really understand it, and contact your accounting firm to discuss implementation,” he advised.
2. Compile as much loss data as you can, in as much detail as you can, as far back as you can. Financial institutions will need to have as much data on losses (charge-offs net of recoveries) for as many loan types as possible, and in as much granular detail as possible. While many community banks lack the same systems and data processing staff that bigger banks may already have in place to capture this kind of data, these smaller institutions can be taking steps right now to gather it, McNairy said.
3. Determine correlation of losses to general economic data, specific risks, etc. A major uncertainty for financial institutions related to the new model is how they will predict future losses that are further out than they are typically used to predicting, McNairy said. An important part of doing this will be determining how losses have historically correlated to rising interest rates, a struggling economy, good or bad news related to the local economy, rising or falling real estate values, or other risks. Banks and credit unions can start doing that research now, he says. “Financial institutions can be asking, ‘How have my losses tracked against some of these macro indicators in the past?’ ”
In the same way banks and credit unions can take steps to prepare for CECL, there are also some measures financial institutions should not be doing ahead of the final standard’s being issued.
1. No early incorporation of expected loss concepts. Financial institution directors in board rooms across the country may wish they could avoid some of the volatility in the ALLL that the new fair-value concept may introduce, but McNairy said it is a definite no-no to begin to incorporate fair-value concepts early. “You have to calculate your allowance in accordance with today’s standards,” he said.
2. No artificial inflation of the ALLL to smooth impact upon adoption. Similarly, McNairy said, banks and credit unions cannot try to retain unjustifiable levels of ALLL in order to reduce future volatility associated with CECL’s implementation. “We cannot manage the P&L because we are worried we are going to have volatility down the road when we adopt the standard,” he said.
3. Do not wait to prepare. “That gets back to gathering as much loss data as you can now, reading the draft standard, understanding what information you have in your financial institution and what other data may be out there — understanding where you find good, relevant economic data,” McNairy said. Some institutions are telling McNairy that they will be able to gather that historical loss data in the future, but he says more banks and credit unions need to begin gathering it now. “Just starting to capture historical loss data, losses by vintage – that will go a long way toward helping the institution feel more comfortable,” he said.
4. Do not overload at adoption. Banks and credit unions should resist the temptation to consider creating “cookie jar reserves” as they adopt the new standards in order to avoid future provisions. This would only be a temptation for institutions with plenty of capital, but it is still a critical “don’t” to keep in mind, McNairy said.
It is important to remember that even if the FASB issues the final CECL model this year, financial institutions will not be expected to implement the changes right away. In the meantime, McNairy noted, bankers can and should take steps to avoid pitfalls with their ALLL under the current incurred-loss model. These steps include properly supporting and documenting each of the following: quantitative factors, qualitative factors, and any unallocated reserves.