CECL: What is the impact to executive compensation?
You have 14 months. Fourteen months until most financial institutions should create a CECL versus incurred-loss model budget. Doing this “practice budget” allows the institution to learn and make changes before they go live with implementation. One line item, the allowance under CECL, could have a huge impact to the bottom line and earnings. The Current Expected Credit Loss (CECL) effective date, of December 15, 2019, is coming quickly for SEC-filing institutions.
The ABA states “Banking regulators have referred to CECL as ‘the biggest change ever to bank accounting.’” It’s more than simply a new way to estimate the allowance, with impact felt throughout a financial institution. Are you willing to base your budget of financial performance on a guess of what your allowance will be under an expected loss model?
Industry experts almost universally agree that the allowance is expected to increase under the new accounting standard. Why should CECL reserves be larger than their incurred-loss counterparts? Mike Lundberg, Partner with RSM US LLP, explained at the 2017 National ALLL Conference, “There are a couple of conceptual differences here. One is the duration. In an incurred loss model, we are cutting off loss events as of a balance sheet date, whereas under CECL, we are forward looking. We have a longer period of time to consider loss events in our reserve.
“The other key theoretical change is removing the threshold. Currently under the FAS 5 model, we have the probable, possible, and remote categories, and a loss has to be probable to be recorded, so our reserve under a current methodology should reflect probable losses. Under CECL, that probable threshold gets pooled, so all the losses, even remote losses, are included.”
Lending professionals surveyed in the 2017 MST CECL Survey of Financial Institutions, agreed. Sixty-five percent said that they expect CECL to increase their reserve amount. Only four percent foresee a decrease in allowance. An increase in allowance could impact the bottom line negatively. And in a domino effect, YOUR income and bonuses could be affected. How comfortable are you “guesstimating” a number that impacts the bottom line of the institution, as well as your own bottom line?
Understanding the impact and volatility of CECL
An institution won’t know the impact of the CECL methodology chosen or the volatility of it until it is tested. MST Senior Advisor Shane Williams, a Subject Matter Expert on financial modeling, says, “Institutions should run dual process for at least a year before creating budgets and forecasts of earnings. You need to know what drives the allowance. Running parallel also allows you to see what methodology or methodologies are better suited to the loan portfolio and make adjustments as needed.”
Running a parallel allowance model
Running this type of Shadow Loss Analysis gives the institution the opportunity to make optimal decisions, whether in an incurred loss model or moving to expected loss. Testing different models, methodologies, and assumptions in a parallel environment using actual institution data is extremely helpful to decision making. Kristen Deitrick, Financial Accountant at Washington Trust, uses a parallel environment for model testing. “Right now, I am running migration and PD/LGD models. I can look at how the allowance calculations differ and how they react with different variables. This helps the CFO to inform the board and manage the capital of the bank for better decision making.”
Speaking of budgets
Executive Vice President of MST John Closs says, “Not only are we educating institutions on thinking through the budget numbers they will have to produce in the coming years, but also, in order to automate the process or to seek external expertise, if that’s the route they choose, that budgeting will need to occur within the next few months of 2017.”
Supply and demand for CECL services
In a blog from April 2017, Economist Tom Cunningham, PhD explains the supply and demand for CECL services. As we draw nearer to expected credit loss, the demand for a third-party solution will increase. The longer you wait, the harder it will be to implement a solution in the most timely and cost-efficient manner.
“There is a limited supply of external expertise available for both the process and the technology,” warns Cunningham, former senior economist of the Atlanta Fed and MST Senior Advisor. “As the implementation deadline approaches, demand for that expertise will increase, and we all know what happens when supply is limited and demand is surging. Establishing relations with the external support necessary for CECL early in the process will assure both availability and cost. Waiting until late in the process when other last-minute institutions are gobbling up resources and bidding up prices is not a sound business decision.”
Yet another decision that could impact the bottom line of the institution and your own bottom line.
Compensation and profitability.
The two are intimately tied together. Are you willing to gamble?
MST is the leader and pioneer in allowance software solutions, advisory services, and education. Financial institutions across the U.S. employ MST to address their allowance requirements, including the software and subject matter expertise to achieve and maintain compliance with U.S. GAAP and the impending CECL accounting standard. MST solutions are tailored for the institution, integrate with core and other lender systems, and exponentially improve efficiencies.