The 2008 financial crisis brought more attention to one crucial aspect of the financial system, which was the delay in the recognition of losses by financial institutions. At the peak of the crisis and under stressed conditions, it became clear that the methodologies and procedures in place at that time (and still in place today within some financial institutions) to estimate reserves resulted in inaccurate, underestimated and untimely allowances for losses.
In order to avoid repeats of the same issue, the Financial Accounting Standards Board (FASB) issued new standards in June 2016 governing the recognition and measurement of credit losses for loans, leases and debt securities. The new approach for calculating current expected credit losses (CECL) will be enforced starting from the end of 2019 for publicly traded institutions (2020 and 2021 for the others). CECL will eventually replace the current standards set by FAS-5 and FAS-114 and will impact all financial institutions regardless of size.
CECL aims to address the expressed concerns of the current models, specifically the classification of losses as probable and incurred. In other words, it attempts to address the fact that, under the current regulation, losses are recognized too late. To address these shortcomings, the CECL approach incorporates forward-looking measures to assess losses throughout the loan lifecycle. The loss projections must also account for the evolution of various macroeconomic scenarios during the same period, which all needs to be formalized.
In fact, institutions must be prepared to back up their projections with data, documentation, procedures and processes, risk models, and related validation. They must highlight why a specific method was chosen as well as reasons why other methodologies were considered and rejected. The required documentation is very comprehensive and must detail the entire process including elements such as:
- Procedures in place to maintain the chosen model
- A summary of the data used in the calculations
- The model validation and assumptions considered
- Adjustments made to the model over time
- The degree of uncertainty present
- Other information relevant to the outcome of the methodology as a whole
CECL will also have a profound impact on organizations. A greater level of cooperation among different functional areas within the organization will be required, especially between credit and finance departments. An impact on the loan-pricing approach and on credit policies is expected as well.
Considering CECL allows institutions flexibility, institutions have plenty of options when it comes to methodologies. Some approaches can be relatively simple, while others can be extremely complicated. At the minimum, the chosen model must include historical information, current conditions, and reasonable and supportable forecasts of future economic conditions. No definition is given regarding the reasonable and supportable aspect of the projections, but the regulators expect institutions to make a good-faith effort to adequately estimate future conditions and avoid contradictory projections.
But be careful!
This freedom comes with a burden. The option to choose a methodology to implement could be overwhelming, especially to smaller institutions. In addition, smaller institutions will face another challenge such as the lack of historical data to perform calculations. If this happens, the best approach is probably to rely on industry data for similar institutions with similar portfolio types.
As expected, loss projections change when moving to the new methodology. Institutions may be required to increase allowances for credit losses. To compensate for the additional reserves, the financial institution may choose to implement different strategies, processes, or even policies. For example, institutions may elect to temporarily raise rates to offset the additional cost. Reshaping the portfolio by focusing on certain product types may also be a viable choice to account for the additional capital.
No organization will face exactly the same challenges or take the exact same steps as another. But in all cases, advanced preparation and a solid project plan can help smooth the process. So while CECL may seem complex and even daunting, compliance deadlines are inevitably approaching. Taking the necessary actions now such as devising a change management plan, determining which data will be needed, choosing the right IT platform, analyzing different methodologies, or exploring third-party providers to help with these activities is crucial to ensure compliance with the new loss standard.
In a nutshell, financial institutions of all sizes will be significantly affected by CECL regulation. The MeridianLink Achieve Analytics team has deep knowledge of data, extensive experience in the analytics field and process consulting sphere.
MeridianLink Achieve can help your institution from A to Z for timely CECL design and implementation while optimizing your allowances. Our approach will significantly reduce your effort and deliver the best possible results.
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Photo Credit: Thomas Leuthard