What is Current Expected Credit Loss (CECL)?
The adoption dates of CECL regulatory requirements are approaching quickly. Partner with ALM First Analytics to prepare your institution for a successful implementation by beginning model planning now. A robust and transparent model is a must, since precision in forecasts directly impacts the bottom line. The CECL model puts additional stress on a financial institution, and your institution needs awareness and planning, a proven model, and expert management.
CECL Pro: A Turn-Key Solution
Impacting institutions of all sizes, CECL requires a shift in organization. A successful new model is based upon strong forecasting methods, trustworthy processing, meticulous data collections, proper accounting integration, and accurate reporting and implementation. ALM First Analytics, as your partner, assists with these necessary components and provides a timely, turn-key solution: CECL Pro.
CECL Pro is the source your institution needs:
- Modeling that produces thorough, transparent analytics
- Runs multi-variable regression analyses
- Performs sensitivity & scenario tests
- Based on statistical rigor & capital markets expertise
- Various concentration analysis abilities (e.g., by geography, indirect dealers, etc.)
- Provides board, auditor, & examiner defense.
Does CECL Apply to Us?
This new accounting approach sprung out of a review of the 2008 financial crisis. Research highlighted that loss recognition prior to the crisis was delayed, and, resultantly, Allowances for Loan and Lease Losses (ALLL) balances were deficient anywhere between 30–60%. In response, the Financial Accounting Standards Board (FASB) formed the Financial Crisis Advisory Group to investigate new options. Thus, the CECL Model took shape, replacing the previous “incurred loss model” with the new “expected credit loss model”:
In addition to forecasting losses at the origination of the loan, the CECL model also requires impairment of existing financial assets on the basis of current estimates of contractual cash flows not expected to be collected by the reporting date. Essentially, at each reporting period, the expected losses will be recalculated, and any changes will flow through earnings.
Losses will be based on current risk ratings and historical loss rates for similar assets, and they will be adjusted for any changes in current conditions or future expectations. The resulting allowance does not relate to any specific asset, but rather relates to pools of assets with similar characteristics.
Making the operational transition to CECL will be a significant undertaking. CECL Pro’s levels of detail and understanding can provide peace-of-mind in implementation and application.
What are the key dates for CECL?
There are several key dates for this new regulatory requirement:
- December 15, 2018 – early adoption is permitted for all organizations.
- December 15, 2019 – implementation is required for public business entities that are SEC filers.
- December 15, 2021 – implementation is required for non-SEC filing public businesses as well as for all other entities and not-for-profit organizations.
How is CECL different from the current approach?
The current “Incurred Loss Model” utilizes an incurred or probable threshold for losses. This is based upon occurrences in the past as well as current conditions that likely caused the impairment.
The “Expected Loss” model does not require any threshold; instead, it looks forward over the entire lifetime of the loan and is based upon past events, current conditions, and reasonable and supportable forecasts.
What balance sheet items does the CECL model impact?
The CECL model applies to loans, Held-to-Maturity (HTM) securities, net investments in leases, and off-balance sheet items such as loan commitments, standby letters of credit, and financial guarantees.
The CECL model does not apply to assets measured at fair value, including Available-for-Sale (AFS) securities and loans held for sale.
Implementation is not required for another couple of years: Why should we focus now?
Although implementation is not required immediately, your institution should start planning today by understanding the data requirements, collecting data, documenting methodologies and assumptions, and forecasting impacts to future capital. Evaluating upcoming annual budgets, educating the board, and forming an Implementation Committee is also smart.
Current tasks which could prove helpful include tracking losses and recoveries by specific product type (e.g., new auto direct, new auto indirect, 15-year mortgages, 30-year mortgages), as CECL will be a smoother process if losses and recoveries are tracked at the product level, and by continuing to refresh FICO scores, debt-to-income (DTI) ratios, and loan-to-value (LTV) estimates.
How far back should historical look-back data go?
There is not a specific look-back period requirement. However, as a rule of thumb, the look-back time period should be at least equal to the average remaining life of the portfolio/segment. Ideally, the institution would utilize data from the past decade in order to incorporate before-and-after financial crisis data.
Is there a required method for forecasting expected credit losses?
No, FASB does not explicitly require any specific calculation model. Different methods ALM First considers and can utilize include a discounted cash flow analysis, average charge-off method, vintage analysis, static pool analysis, migration analysis, and probability-of-default method.
What discount rate does the CECL model use?
The CECL model applies the effective interest rate (the book rate at origination adjusted for any net deferred fees, costs, premiums, or discounts) as the discount rate. Doing so applies the same credit indicators (FICO, term, LTV, etc.) the institution used when underwriting the loan. Moreover, this valuation is not intended to represent fair market value, but rather highlight future expected losses.
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“ALM First” is a brand name for a financial services business conducted by ALM First Group, LLC (“ALM First”) through its wholly owned subsidiaries: ALM First Financial Advisors, LLC (“ALM First Financial Advisors”); ALM First Advisors, LLC (“ALM First Advisors”); and ALM First Analytics, LLC (“ALM First Analytics”). Investment advisory services are offered through ALM First Financial Advisors, an SEC registered investment adviser. Balance sheet advisory services are offered through ALM First Advisors. Financial reporting services, loan introduction services, and other special project services are offered through ALM First Analytics. Neither ALM First nor any of its subsidiaries provide legal, tax, or accounting advice.
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