The Current Expected Credit Loss Model and How Financial Institutions Should Prepare

The Financial Accounting Standards Board issued the final standard on the Current Expected Credit Loss (CECL) model in June 2016. The standard aims to better project possible losses inherent in a financial institution’s loan or securities portfolio to better prepare for potential economic difficulties. Billed as an overhaul to the calculation of the Allowance for Loan and Lease Losses (ALLL), some industry members are calling CECL the largest change to ever impact accounting for financial institutions.

Significant changes in the standard
Currently, financial institutions use a historical loss model to project losses into the future, with certain qualitative factors put in place to evaluate potential changes in the institution, market, or portfolio. The movement towards CECL will put more of an emphasis on a forward-looking approach, rather than placing significant weight on the historical losses incurred. Current ALLL calculations vary significantly from institution to institution, and generally follow a trend of sophistication similar to that of the institution’s overall business model.

At this time, there is no specific method suggested by FASB or regulators to perform the ALLL calculation under CECL. There has been conversation within the industry that the calculation should continue to follow a complexity curve similar to that of the institution’s business model. The calculation for a $100 million institution in a rural area with a concentration in one major loan type is expected to be significantly less complex than an institution of $1 billion or more with numerous concentrations in a wider range of loan types.

How should the industry prepare?
As mentioned above, a significant portion of input data for current ALLL calculations is based on historical losses. Although the level of sophistication of the calculation is expected to scale with the complexity of the institution, management should begin to gather as much relevant data as possible minimize the effects of compliance at the implementation date. Vintage analysis has been considered as a starting point for initial calculations. Loans would be separated by pool and origination year, and loss histories documented to determine how each pool performed over the life of the loan. However, vintage analysis provides for a potential negative in that a fully developed vintage will contain loans that were originated five or more years in the past as of the time of implementation.

Generally, the basic information needed for each pool should be available through the institution’s core processing system. However, if an institution is unable to maintain reports beyond a certain window, it is in its best interest to begin archiving relevant data as soon as possible.

How will this affect the calculated allowance?
During the development of CECL, regulators forecasted potential increases in required reserves of up to 50%. However, this prediction was based around the uncertainty of the final standard requirements, and the initial adjustment is not expected to be as significant as once thought. At the time of implementation, the institution is expected to make a one-time entry to retained earnings for any adjustments as of the implementation date. Note that institutions should not begin to gradually increase the recorded allowance in preparation for the implementation, as this treatment does not comply with GAAP.

When does CECL take effect?
For public business entities, CECL will take effect for annual periods beginning after December 15, 2019, and for interim period reports filed beginning March 31, 2020. For non-public business entities, the standard will take effect for annual periods beginning after December 15, 2020, and for call reports filed beginning December 31, 2021.

For more information about this and other changes in the banking industry, please contact us.


Written by:

David Attaway