The relationship between fair value and the allowance has changed. Particularly for acquisitive institutions, there are real implications stemming from the CECL model application, vendor selection, and valuation processes. When executed thoughtfully, the implications can be understood and minimized.
Under the incurred loss model (450-20), an allowance wasn’t recorded for newly acquired assets. Purchased Credit Impaired (PCI) instruments were accounted for under 310-30 (SOP 03-3), which required maintenance of a separate allowance account (‘impairment’), periodic cash flow estimations, and periodic re-yielding/impairment analysis. Additionally, instruments that were not identified as PCI were considered to have an adequate allowance due to the credit component included in the fair value adjustment. Because of this interpretation, there was no allowance recorded for non-PCI instruments until the estimated allowance exceeded remaining discount. Even then, the allowance generally reflected the shortfall only.
Now, reserves are required on Day 1, which can be a challenge for some financial institutions. This means that newly-acquired loans will need to be included in allowance models and their reserve reflected on the balance sheet. Whether the reserve is recognized through a provision expense on the income statement or merely a balance sheet entry is determined by the instruments’ Purchased Credit Deteriorated (PCD) designation: PCD = balance sheet while non-PCD = income statement.
The solution, as we see it, is relatively simple: CECL and valuation calculations should be done in the same environment by those familiar with the implications of these decisions. Ideally, prior to the close date, the acquiring institution should have a notional valuation, a notional CECL calculation, and both should be operable models going forward. For example, when one of our clients announces an acquisition, we prepare their CECL models for ongoing calculations while simultaneously preparing preliminary valuation estimates as well as their Day 1 valuation. This practice not only assists with the operational burden of standing up an allowance model, but it also prepares management with critical expense and/or payback intelligence.
Another challenge that arises when relating CECL and fair value is the variance between exit price disclosure and Day 1 valuations. The fair value disclosure isn’t new, but the requirement to use an exit price notion is new with the introduction of ASU 2016-01. When different modeling assumptions, different vendors, or different models are used relative to the Day 1 valuation, difficult and unexplainable differences may arise. During this transition period, we’ve seen disclosure presentations reflecting wildly different fair value estimates with only days separating the two calculations.
One simple solution is to use the same model and process for Day 1 valuations and exit price disclosures. Of course, the same model would result in the same answer given the same ‘as-of’ date.
There are distinct differences between fair value and CECL calculations. However, there are distinct similarities as well, and navigating both requires domain knowledge and thoughtfully built systems. Clients that have partnered with Abrigo for CECL and valuation services will be well-positioned to address these new challenges. Most importantly, Abrigo clients won’t be surprised on Day 1 or Day 2.
Despite the challenges associated with adjusting long-term strategic initiatives, banks and credit unions have a unique opportunity to consider ways to make more informed, data-driven decisions amid coronavirus implications. Consolidating key systems and processes that aggregate data, like CECL modeling results and fair value, can give decision makers easier access to data and a more comprehensive view of the financial ecosystem, which will maximize the chances for successful strategic decisions. Given the current competitive landscape and economic challenges, any advantage is worth exploring.