The Current Expected Credit Loss (CECL) model — viewed by many as the biggest change in the history of bank accounting — was finalized in June 2016 and takes effect beginning in 2020. Nonpublic business entities (non-PBEs), including many community banks, must implement the new model for fiscal years beginning after December 15, 2020, and for interim periods in fiscal years beginning after December 15, 2021.
Recently, federal banking regulators issued a joint statement to answer frequently asked questions (FAQs) about the new accounting standard. The FAQs explain CECL and outline the steps banks should take to plan and prepare for the transition to, and implementation of, the new standard.
The New Standard in a Nutshell
The new standard, found in Accounting Standards Update (ASU) No. 2016-13, discards today’s incurred-loss model, which delays recognition of credit losses until they become “probable,” in favor of a forward-looking approach. Banks now will recognize an immediate allowance for all expected credit losses over the life of loans held for investment, held-to-maturity debt securities and other covered financial assets.
To estimate expected losses, banks will consider a broader range of data than they do under current standards, including historical and current information. For many banks, implementing the new standard will cause them to increase their allowances for loan and lease losses (ALLL), which will have an impact on earnings and capital.
10 Steps to Take
The FAQs encourage banks to prepare for CECL implementation by taking these 10 steps:
1. Become familiar with the new accounting standard. Educate the board and appropriate staff about how CECL differs from the current methodology
2. Determine the applicable effective date. The effective date for non-PBEs is noted above. Institutions that are SEC filers or otherwise satisfy the definition of PBE must implement CECL earlier.
3. Create a timeline. Determine the steps and timing needed to implement the new standard.
4. Identify the functional areas that should participate in implementation (for example, accounting/finance, audit, credit risk management, operations, IT). A good way to start is to review your current process for determining credit losses and establishing the ALLL, and identifying the departments and staff involved.
5. Discuss the new standard with the board, audit committee, external auditors, industry peers and regulators. This will help determine an implementation strategy that’s appropriate in light of your bank’s size, activities and risk profile.
6. Identify existing ALLL and credit risk management practices that can be leveraged when applying the new standard. Use what you already have in place that doesn’t need to change, and modify existing tools and processes as necessary.
7. Determine the allowance estimation method or methods to be used. The FAQs emphasize that CECL is scalable to institutions of all sizes. The regulatory agencies do not expect smaller, less complex institutions to adopt complex modeling techniques.
8. Identify currently available data and any additional data you need to collect and maintain going forward to implement the new standard. It’s critical to begin collecting any new data as early as possible so you’ll have time to accumulate the data you need to implement CECL. Your bank’s data requirements will depend on the allowance estimation methods you select, but the FAQs provide examples of the types of data you may need to collect:
- Loan origination and maturity dates,
- Loan origination par amount,
- Initial and subsequent loan charge-off amounts and dates,
- Loan recovery amounts and dates, and
- Cumulative loss amounts for loans with similar risk characteristics.
9. Identify system changes needed to implement the new standard. These must be consistent with your chosen allowance estimation methods.
10. Evaluate and plan for the new standard’s potential impact on regulatory capital. According to the FAQs, upon initial adoption CECL “will likely increase allowance levels and lower the retained earnings component of equity, thereby lowering common equity tier 1 capital for regulatory capital purposes.” But the regulators emphasize that the actual impact will vary from institution to institution based on several factors, including existing allowance balances, portfolio mix, underwriting practices, institution and borrower locations, and current and expected economic conditions.
Start Planning Now
Although implementation of CECL is more than three years away for many community banks, it’s a good idea to start the planning process now. Getting an early start is particularly important if your bank will need to adjust its data collection practices, modify its internal controls or update its IT systems to prepare for implementation.
Sidebar: Should You Be Stress Testing Your Capital?
In light of the Current Expected Credit Loss (CECL — see main article) model’s potential impact on regulatory capital, banks should consider stress testing their capital. Stress testing can be a powerful tool for evaluating the impact of hypothetical adverse events on a bank’s earnings, capital adequacy and other performance measures. The Office of the Comptroller of the Currency (OCC) considers annual stress testing or sensitivity analysis of loan portfolios to be a key component of sound risk management for community banks.
As part of your capital planning process, it’s a good idea to use stress testing to evaluate the worst-case-scenario impact of CECL on your bank’s capital adequacy. Armed with this information, you can determine whether to take steps to raise new capital or reduce risk as CECL’s implementation date approaches.