Articles & E-Books

 

Measuring the impact of CECL adoption

Aug 12, 2020

The adoption of Accounting Standards Codification (ASC) 326 – Financial Instruments – Credit Losses (CECL) has been met with nervous anticipation from bankers since it was first introduced in 2016.

CECL is a significant change in how banks estimate their allowance for loan and lease losses (ALLL). Prior to CECL, banks estimated the ALLL using an incurred loss model, which meant that losses were recognized when it became probable that losses would be incurred, and loss estimates were generally based on historical experience with certain qualitative adjustments. CECL requires banks to make an estimate of credit losses for the remaining estimated life of the loans using historical experience, current conditions, and reasonable and supportable forecasts. The key change with CECL is that losses are no longer estimated when incurred but are instead estimated at loan inception for the life of the loan.

There has been much speculation about how much the ALLL would increase with the change from the incurred loss model to CECL. We are beginning to see the first glimpses of that change. Calendar year-end SEC filers that are not smaller reporting companies or did not use the CARES Act provision to delay adoption had to adopt CECL as of January 1, 2020. A company generally qualifies as a smaller reporting company if it has public float of less than $250M or has less than $100M in annual revenues and no public float or public float of less than $700M.

The impact of COVID-19

We reviewed the ALLL to Average Loans for just over 5,000 U.S. banks. The table below summaries total banks by the various asset sizes.

Asset size

Banks

Less than $1B

4,277

$1B - $3B

502

$3B - $10B

176

$10B-$50B

98

Total

5,053

The table below summarizes the average ALLL to Average Loans over the last six quarters by various asset sizes.

ALLL to average to average loans graph

As reflected above, prior to March 31, 2020, the ALLL to Average Loans remained relatively stable or declined slightly in all asset bands as banks benefited from a strong economy and positive credit metrics.

As of March 31, 2020, that trend changed. There are two primary reasons for that change. First, in March 2020, the U.S. economy was significantly impacted by COVID-19, resulting in a negative impact on businesses and consumers, as well as a dramatic increase in unemployment. The impact to businesses and consumers had a direct impact on all banks, resulting in increased provisioning and an increase in ALLL to Average Loans across all asset bands in our analysis. The impact was less pronounced in the less than $1B asset band and gradually increased across the larger asset bands.

Second, March 31, 2020, was also the first quarter that many banks were required to report quarter-end results under the new CECL standard. Banks impacted by CECL generally have assets of at least $3B, as they are most likely SEC filers that are not smaller reporting companies. However, the chart above does not delineate or provide a clear picture of the change in ALLL to Average Loans caused by CECL because not all banks over $3B were required to adopt CECL because of their SEC filing status or elected to defer based on provisions within the CARES Act.

The impact of CECL adoption

To better gauge the impact of CECL adoption without the effects of COVID-19, we reviewed 152 SEC banks with assets between $3B and $50B. Of those banks, 105 adopted CECL in 2020 and 47 did not. Presented below is the ALLL to Average Loans for the prior six quarters bifurcated between banks that adopted CECL and those that did not.

ALLL to average loans based on CECL adoption 

The chart above reflects a 22bps difference in the March 31, 2020, ALLL to Average Loans between the banks that estimated the ALLL under CECL and those that continue to estimate the ALLL using the incurred loss model. For the five quarters prior to March 31, 2020, the ALLL to Average Loans ratio spread between those banks that adopted CECL in 2020 and those that did not was never more than 10 basis points.

During Q1 2020, banks that continued to report under the legacy incurred loss methodology reported a quarterly increase in the ALLL to Average Loans of 29% or 25 basis points. It is highly likely this is due to both the real-time and forecasted economic impact of the COVID-19 pandemic.

During Q1 2020, banks that adopted CECL reported a quarterly increase in ALLL to Average Loans of 73%, or 56 basis points, and 31 basis points more than their peers that did not adopt CECL.

Smaller bank impact

Nearly 85% of U.S. banks are less than $1B in total assets and very few, if any, of these banks have adopted CECL. Generally, smaller banks have carried a higher ALLL to Average Loans ratio than their larger peers. With the adoption of CECL, banks that adopted CECL and those with less than $1B in total assets had very similar ALLL to Average Loans ratios as of March 31, 2020.

There are many factors that go into the development of the ALLL estimate under CECL. Smaller banks are slated to adopt CECL January 1, 2023, and it remains to be seen if smaller banks will see a similar increase in the ALLL to Average Loans ratio as their larger peers that recently adopted the standard. Most industry experts expect to see an increase in the ALLL to Average Loans for all adopters. As the chart below reflects, the ALLL to Average Loans gap between adopters and non-adopters has narrowed at March 31, 2020.

Avereage loss of allowance to loans

Future impact of CECL adoption

Although the impact for many banks remains to be seen as most banks are not required to adopt CECL until 2023, our review of 152 banks with assets of $3B to $50B shows adoption of CECL will likely result in material impact to banks ALLL to Average Loans. On average, all banks saw an increase in the ALLL to Average Loans for the quarter ending March 31, 2020, but banks that adopted CECL reported a much larger increase — 44% more than those that had not adopted CECL.

This is the first of a planned three-part series for 2020 where we will follow the migration of the ALLL for CECL adopters compared to non-adopters, as well as the impact of the COVID-19 pandemic. 

If you’d like to learn more about CECL and how Wipfli can help you adopt the standard, click here.

Or continue reading on:

CECL easy button

CECL: Are you procrastinating?

Author(s)

John Erwin
John Erwin, CPA
Senior Manager
View Profile
Sonny MacArthur
Sonny MacArthur, CPA, CIA
Partner
View Profile
COVID-19 resource center
Insights to help you respond to and recover from coronavirus fallout.
Learn more