Banks, credit unions and other types of financial institutions are preparing for the imminent approach of the credit losses standard.
The standard is often referred to CECL in reference to the current expected credit losses model used by the Financial Accounting Standards Board in its version of the standard under U.S. GAAP. FASB wasn’t able to fully converge its financial instruments standard with the International Accounting Standards Board’s approach under International Financial Reporting Standards, so the differences are likely to complicate the implementation for international banks. There are also different dates for adoption by public and private companies, and FASB recently agreed to adjust the effective date slightly for private companies in keeping with the approach it used for the earlier revenue recognition and leasing standards, where private companies get a full extra year to implement a standard. But for both publicly traded and privately held banks, the date isn’t far off.
“If you’re a public business entity, you have to be ready at the end of 2019,” said Mason Mullins, a senior manager in the Charlotte office of the Top 100 Firm Elliott Davis. “For non-public business entities it’s predominantly going to be 2021 for the private community banks and credit unions. For most of them, they’re going to have to adopt the new CECL standard in 2021 for calendar year-end companies.”
The large publicly traded banks are naturally further along in the process, in many cases already comparing their financial statements under both the old and new standards.
“If we want to talk about the Bank of Americas and the JP Morgans, I think they’re probably running parallel right now this year,” said Mullins. “They’ll have year-end disclosures at the end of 2019, and then they’ll be fully adopted at the beginning of 2020.”
Privately held organizations get some more time to work on the transition. “Right now a lot of these community banks are trying to assess their data, and how far back they can look at historical charge-off rates,” said Mullins. “One of the major changes in the standard with CECL is now we have to estimate the expected lifetime losses on those credit exposures versus the old FAS 5 legacy GAAP where there’s the probability of a loss, in which case you’re waiting for the borrower to miss a payment or you get notified that they’ve lost their job or some other triggering event. In that case you would take your most current annual charge-off rate and start to adjust it, but under CECL now you’re going to be looking at what’s been your lifetime historical loss rate experience.”
To deal with the new standard, many banks have to go back in time to see what they’ve been doing. “At the community bank level, management is really trying to dig up all the data they have going back five, 10-plus years, in some cases, ensuring that data is complete and accurate,” said Mullins. “Then, from there, once they’re comfortable with the historical data, they are starting to think about what type of estimation method they’re going to use, and what’s most appropriate for their loan portfolio, and then also thinking about other changes to the end-to-end allowance process.”
CECL is likely to have a wide impact on how banks account for loans. “It is going to change control, especially around governance,” said Mullins. “CECL is going to really include management’s view on macroeconomic outlooks, because CECL is now going to include forward-looking assumptions. Under current or what will be legacy GAAP, you didn’t use forward-looking assumptions such as the unemployment rate or views on GDP and home prices. So management is looking to revamp their governance process. Then, by the beginning of 2020, the community bank network is looking to essentially run parallel their new CECL models with the legacy allowance models, so they can start to see what the differences are between an incurred loss view versus an expected lifetime view of losses, and what that analysis or differences are. I think everyone’s presumption is this is going to have a very sizable impact on capital. They’ll take more of a reserve on the balance sheet, and then there’s more volatility in the P&L as management’s view of the macroeconomic environment changes in each period that they’re remeasuring for their reserve.”
He believes the private banks still have a lot of work to do to get ready for the new standard. “In actual quantitative terms, for the private banks and financial institutions, we’re still not there yet,” said Mullins. “They’re still trying to determine their models, whether they’re going to do an Excel-based model internally, or whether they’re going to outsource it to a vendor. There are probably a half-dozen or so vendors out there in the marketplace that are marketing to community banks. I think the backbone of those are Excel-based. They just put them into an online dashboard so there’s more P&L metrics and credit metrics for executive-level management.”
In the end, the standard-setters hope the banks will get a more realistic view of the extent of their loan losses, which could help mitigate a future credit crisis like the kind experienced a decade ago. But Mullins isn’t so sure.
“I think time will tell,” he said. “Certainly if we hit another credit bottom, at that point we will have the luxury of hindsight to look at what management’s assumptions were and the vetting process that they went through to estimate lifetime credit losses, and at that point we’ll be able to do some backtesting. The intentions are right with what’s been in the works by FASB and the industry over the last four to five years. Nobody wants to be blindsided again with another economic downturn and being under-reserved on the balance sheet, which was the case when we hit the bottom in 2009. For me I think the question is it’s going to be a bit of a balancing act between providing relevant expectations as to management’s views of credit losses, but also not having views or assumptions that are not realistic to the extent that it curtails lending to bank customers, or drives up prices on loans too high so that it prices a lot of borrowers out of the market. I think it will be a bit of a balancing act between what’s going to be better for the public in terms of them accessing capital for their credit needs, whether it’s home loans or auto loans or student loans, and then also providing relevant and sound data to investors.”
