CECL Overview

CECL: FASB’s new standard for calculating allowances for loan and lease losses (ALLL).  


The Financial Accounting Standards Board (FASB) is responsible for developing and issuing U.S. Generally Accepted Accounting Principles (U.S. GAAP) standards, one of which is how institutions establish an allowance for loan and lease losses (ALLL). Under existing Generally Accepted Accounting Principals (“GAAP”), allowance for loan and lease losses (“ALLL”) are recognized when it is “probable” a loss has been incurred. The financial crisis was exacerbated by the inability of market participants to understand banks’ exposures and expected credit losses. Money markets seized up, banks struggled to access credit and bank equity and debt sold off. The existing requirement a loan loss must be incurred before recognized in ALLL delayed the recognition of loan losses, the July 2009 report of FASB’s Financial Crisis Advisory Group concluded, citing the results of the first stress tests. In June 2016, FASB issued its revised ALLL standard as the current expected credit loss standard (CECL). Under CECL, when a bank originates a loan, the total expected credit losses over the contractual life of the exposure are recognized. CECL requires a forward-looking approach that would allow for ALLL to build in anticipation of expected losses and earlier than under the incurred loss standard. However, determining expected losses requires risk managers to make subjective assumptions about future conditions.

 

 

 

GAAP’s new CECL  standard: incurred probable loss impairment  vs expected credit losses

 

CECL is applicable to all financial assets carried at amortized cost (e.g., held-for-investment (HFI) loans and held-to-maturity (HTM) securities). Whereas the old incurred loss regime required an ALLL when an asset is deemed “impaired” because it is “probable that a loss has been incurred,”[i] the changes promulgated under CECL compel ALLL based on the “net amount expected to be collected” based upon “management’s current estimate of expected credit losses on an asset.”[ii]

 

CECL changes threshold for reporting ALLL from an incurred loss methodology to an expected credit loss methodology by requiring financial institutions to 1) use information that is more forward-looking and 2) recognize the lifetime expected credit losses as of the reporting date for all eligible financial assets including newly originated or acquired assets. Under CECL, the ALLL is the difference between the financial assets’ amortized cost basis and the net amount expected to be collected on the financial assets.

 

In determining the net amount expected to be collected, institutions are required to use information about past events, current conditions, and reasonable and supportable forecasts relevant to assessing the collectability

 

CECL Implementation Deadlines  

 

SEC Filers – Effective for fiscal years, and interim periods within those fiscal years, beginning after Dec. 15, 2019. Thus, for a calendar year company, would be effective Jan. 1, 2020.
 Public Non-SEC Filers – Effective for fiscal years, and interim periods within those fiscal years, beginning after Dec. 15, 2020.

Thus, for a calendar year company, would be effective Jan. 1, 2021.

All Other Organizations – Effective for fiscal years, and interim periods within those fiscal years, beginning after Dec. 31, 2021.

Thus, for a calendar year company, would be effective Jan. 1, 2022.

Early Application – All organizations can elect to apply for fiscal years, and interim periods within those fiscal years, beginning after Dec. 15, 2018.

Hence, calendar year companies may elect to begin following the guidance as early as Jan. 1, 2019.

 

CECL’s New Priorities and Goals

 

CECL requires a forward-looking approach that would allow for ALLL to be calculated in anticipation of expected losses and earlier than under the incurred loss standard.

 

326-20-30-1: “The allowance for credit losses is a valuation account that is

deducted from the amortized cost basis of the financial asset(s) to present the net amount expected to be collected on the financial asset. At the reporting date, an entity shall record an allowance for credit losses on financial assets within the scope of this Subtopic. An entity shall report in net income (as a credit loss expense) the amount necessary to adjust the allowance for credit losses for management’s current estimate of expected credit losses on financial asset(s).”

 

CECL’s methodology for calculating expected loss

 

CECL forecasts should be grounded in:

 

Current conditions relevant to the lender and borrower
Ability to revert to historical loss to forecast beyond period for which bank can make a reasonable and supportable forecast
Relevant historical losses from internal or external sources

 

326-20-30-9: “An entity shall not rely solely on past events to estimate expected credit losses…The adjustments to historical loss information may be qualitative in nature and should reflect changes related to relevant data (such as changes in unemployment rates, property values, commodity values, delinquency, or other factors determined in accordance with paragraph 326-20-30-8  that are associated with credit losses on the financial asset or in the group of financial assets) ...However, an entity is not required to develop forecasts over the contractual term of the financial asset or group of financial assets. Rather, for periods beyond which the entity is able to make or obtain reasonable and supportable forecasts of expected credit losses, an entity shall revert to historical loss information hat is reflective of the contractual term of the financial asset or group of financial assets. An entity shall not adjust historical loss information for existing economic conditions or expectations of future economic conditions for periods that are beyond the reasonable and supportable period…An entity may revert to historical loss information immediately, on a straight-line basis, or using another rational and systematic basis.”

 


GAAP’s new CECL  standard: incurred probable loss impairment  vs expected credit losses

 

CECL forecasts should be grounded in:

 

Current conditions relevant to the lender and borrower
Ability to revert to historical loss to forecast beyond period for which bank can make a reasonable and supportable forecast
Relevant historical losses from internal or external sources

 

326-20-30-9: “An entity shall not rely solely on past events to estimate expected credit losses…The adjustments to historical loss information may be qualitative in nature and should reflect changes related to relevant data (such as changes in unemployment rates, property values, commodity values, delinquency, or other factors determined in accordance with paragraph 326-20-30-8  that are associated with credit losses on the financial asset or in the group of financial assets) ...However, an entity is not required to develop forecasts over the contractual term of the financial asset or group of financial assets. Rather, for periods beyond which the entity is able to make or obtain reasonable and supportable forecasts of expected credit losses, an entity shall revert to historical loss information hat is reflective of the contractual term of the financial asset or group of financial assets. An entity shall not adjust historical loss information for existing economic conditions or expectations of future economic conditions for periods that are beyond the reasonable and supportable period…An entity may revert to historical loss information immediately, on a straight-line basis, or using another rational and systematic basis.”

 

CECL’s methodology “Reasonable and Supportable” forecast period  

 

CECL’s mandates that

 

An institution has the ability to forecast an instance in time based on historical loss and current relevant conditions,  and
Such Forecasts should be “Reasonable and Supportable”

 

326-20-30-9: An entity shall not rely solely on past events to estimate expected credit losses…The adjustments to historical loss information may be qualitative in nature and should reflect changes related to relevant data (such as changes in unemployment rates, property values, commodity values, delinquency, or other factors determined in accordance with paragraph 326-20-30-8  that are associated with credit losses on the financial asset or in the group of financial assets) ...However, an entity is not required to develop forecasts over the contractual term of the financial asset or group of financial assets. Rather, for periods beyond which the entity is able to make or obtain reasonable and supportable forecasts of expected credit losses, an entity shall revert to historical loss information hat is reflective of the contractual term of the financial asset or group of financial assets. An entity shall not adjust historical loss information for existing economic conditions or expectations of future economic conditions for periods that are beyond the reasonable and supportable period…An entity may revert to historical loss information immediately, on a straight-line basis, or using another rational and systematic basis.”


 


CECL’s methodology: Ability to revert to historical loss  

 

Historical losses can be adjusted to take into Account relevant macroeconomic data such as:

 

Credit Cycle: Expanding or contracting credit cycle

 

 

326-20-30-9: An entity shall not rely solely on past events to estimate expected credit losses…The adjustments to historical loss information may be qualitative in nature and should reflect changes related to relevant data (such as changes in unemployment rates, property values, commodity values, delinquency, or other factors determined in accordance with paragraph 326-20-30-8  that are associated with credit losses on the financial asset or in the group of financial assets) ...However, an entity is not required to develop forecasts over the contractual term of the financial asset or group of financial assets. Rather, for periods beyond which the entity is able to make or obtain reasonable and supportable forecasts of expected credit losses, an entity shall revert to historical loss information hat is reflective of the contractual term of the financial asset or group of financial assets. An entity shall not adjust historical loss information for existing economic conditions or expectations of future economic conditions for periods that are beyond the reasonable and supportable period…An entity may revert to historical loss information immediately, on a straight-line basis, or using another rational and systematic basis.”



 

 

CECL’s methodology: Considering Historical Losses

 

Data documenting historical loss can be from both internal and external sources
Data sources are required to adjust for current credit grades
Data sources must account for portfolio mix changes and credit quality changes

Paragraph  326-20-30-7  “When developing an estimate of expected credit losses on financial asset(s), an entity shall consider available information relevant to assessing the collectibility of cash flows. This information may include internal information, external information, or a combination of both relating to past events, current conditions, and reasonable and supportable forecasts.”

 

Paragraph 326-20-30-9 “Historical loss information can be internal or external historical loss information (or a combination of both). An entity shall consider adjustments to historical loss information for differences in current asset specific risk characteristics, such as differences in underwriting standards, portfolio mix, or

asset term within a pool at the reporting date or when an entity’s historical loss

information is not reflective of the contractual term of the financial asset or group

of financial assets.”


 


At Brean, we have developed three solutions to enable financial institutions to satisfy their CECL requirements. 

1. Top Down Expected Loss Model. This allows institutions to choose a forecasted macroeconomic scenario which best represents the view of their management. Our model has calculated the expected loss for each scenario based on a statistical regression analysis of other similar banks in the region. The tool also allows an institution to review their historical performance by region alongside the economic indicators.

2. Bottom Up Model. For institutions which want more granularity in their forecast, Brean has also constructed a loan level model based on the statistical analysis of the historical performance of a universe of securitized and bank whole loans.

3. Data Warehouse. Many of our clients find it difficult to aggregate piecemeal data which might be culled from a combination of asset-liability management extracts with loan and rate information, origination and underwriting data with the relevant credit metrics and servicer data with the loan’s current performance status. Brean’s team of data scientists can help financial institutions aggregate their data into a data warehouse, enrich the data with local home prices and unemployment and render this data on a portal for use in risk reporting. In one representative data analytics engagement, Brean built a loan origination and performance database from 400 million data points which is now relied upon by leading asset managers and investors for a multi-billion dollar sector.


CECL Overview The Financial Accounting Standards Board (“FASB”) issued Current Expected Credit Loss (“CECL”) rules for loan losses which take effect for the fiscal years beginning after December 15, 2019 for public reporting Securities and Exchange Commission filers and December 15, 2020 for other entities. Under existing Generally Accepted Accounting Principals (“GAAP”), allowance for loan and lease losses (“ALLL”) are recognized when it is “probable” a loss has been incurred. The financial crisis was exacerbated by the inability of market participants to understand banks’ exposures and expected credit losses. Money markets seized up, banks struggled to access credit and bank equity and debt sold off. A key premise of the stress tests then Treasury Secretary Geithner rolled out in February 2009 was to facilitate a “forward looking assessment” about the risk on bank balance sheets. The existing requirement a loan loss must be incurred before recognized in ALLL delayed the recognition of loan losses, the July 2009 report of FASB’s Financial Crisis Advisory Group concluded, citing the results of the first stress tests. Whereas the old incurred loss regime required an ALLL when an asset is deemed “impaired” because it is “probable that a loss has been incurred,”[i] the changes promulgated under CECL compel ALLL based on the “net amount expected to be collected” based upon “management’s current estimate of expected credit losses on an asset.”[ii] The new CECL regime is not proscriptive. CECL can be calculated “on a collective or individual basis,” for example.[iii] At the highest level, a firm’s CECL must be grounded in: 1) current conditions and relevant quantitative and qualitative factors which relate to the environment in which the lender operates and which are specific to the borrower[iv] such as unemployment rates, property values, commodity prices or delinquency;[v] 2) internal or external data or a combination of both;[vi] and, 3) reasonable and supportable forecasts.[vii] At Brean, we have developed three solutions to enable financial institutions to satisfy their CECL requirements. 1. Top Down Expected Loss Model. This allows institutions to choose a forecasted macroeconomic scenario which best represents the view of their management. Our model has calculated the expected loss for each scenario based on a statistical regression analysis of other similar banks in the region. The tool also allows an institution to review their historical performance by region alongside the economic indicators. 2. Bottom Up Model. For institutions which want more granularity in their forecast, Brean has also constructed a loan level model based on the statistical analysis of the historical performance of a universe of securitized and bank whole loans. 3. Data Warehouse. Many of our clients find it difficult to aggregate piecemeal data which might be culled from a combination of asset-liability management extracts with loan and rate information, origination and underwriting data with the relevant credit metrics and servicer data with the loan’s current performance status. Brean’s team of data scientists can help financial institutions aggregate their data into a data warehouse, enrich the data with local home prices and unemployment and render this data on a portal for use in risk reporting. In one representative data analytics engagement, Brean built a loan origination and performance database from 400 million data points which is now relied upon by leading asset managers and investors for a multi-billion dollar sector.

 


[i] FASB 310-10-35-4 (superseded by Accounting Standards Update No. 2016-3 [ii] FASB 326-20-30-1. [iii] FSAB 326-20-30-7. [iv] FASB 326-20-30-7 (in estimating expected credit losses on financial assets, “[a]n entity shall consider relevant qualitative and quantitative factors that relate to the environment in which the entity operates and are specific to the borrower(s)”) [v] FASB 326-20-30-9. [vi] Id. (explaining “an entity is not required to search all possible information that is not reasonably available without undue cost and effort.) [vii] FASB 326-20-30-9 (noting “[a]n entity shall not adjust historical loss information for existing economic conditions or expectations of future economic conditions for periods that are beyond the reasonable and supportable period.”)

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