The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-13 Financial Instruments – Credit Losses (Topic 326) in June 2016 and introduced the current expected credit losses (CECL) methodology for estimating allowances for credit losses (ACL).
After many delays, institutions that have not adopted CECL will generally be required to replace their current incurred loss model (ILM) for estimating the allowance for loan and lease losses (ALLL) with CECL beginning in 2023.
Learn from those who have already adopted
Institutions that have not yet adopted CECL have the advantage of learning from those who have already made the change. CECL adoption takes considerable time, effort and coordination within institutions.
Most adopting institutions had to work through unanticipated issues transitioning to CECL that only became apparent by running parallel CECL and current ILM for multiple periods.
Additionally, nearly as soon as those institutions issued financial statements with CECL related disclosures, COVID-19 created additional complexities that necessitated additional analysis and a real life trial pushing the stress testing of many models.
Chose how you will adopt
CECL does not prescribe one method that must be used to estimate the ACL, so a key consideration institutions should make now is what method they will choose within the CECL framework to estimate the ACL.
What method is appropriate for each institution depends on the complexity and nature of an institution’s loans. Many adopting larger institutions use sophisticated models to estimate the ACL that likely are unnecessary and impractical for smaller institutions. We anticipate that many smaller institutions will use a weighted average remaining maturity (WARM) method to estimate their ACL as it is similar to current ILMs.
However, a WARM method will not be appropriate for all institutions. Institutions should carefully consider various potential methods for adoption to determine what is most appropriate for their circumstances.
In-house or third-party assistance
In conjunction with deciding which method to utilize, institutions should also determine if they have the knowledge, expertise and desire to perform the calculation in-house or if they will engage third-party assistance.
Electing to use a third-party service provider may make initial adoption and ongoing calculations easier to manage. However, management must understand and take ownership of their ACL and not simply allow a third-party servicer to be the black box calculation that determines their ACL.
If a third-party is utilized, management must work closely with the third-party to ensure management understands the model and the selected service provider is included within the institution’s third-party risk management system.
Parallel CECL and ILM calculations are essential
To allow time to work through implementation issues that surely will arise, we recommend that institutions run parallel CECL and ILM for at least one year prior to adoption.
With less than six quarters remaining until required adoption, the time is now for all institutions to determine how they will adopt CECL so parallel calculations can be run throughout 2022.
Only by running parallel calculations can institutions ensure that all necessary data is available, internal controls are in place, and communications between management and those charged with governance are effective prior to required CECL adoption.
Adoption impact and other considerations
Although the average impact of CECL adoption may be about a 30% increase in the ALLL, that does not mean that increase is what all institutions should expect as loan portfolios differ significantly.
Some institutions will experience a higher than average increase when they adopt CECL, and others may see a reduction in the ALLL. The only way an institution can estimate for itself the impact of adoption is to run parallel ILM and CECL calculations, and that necessitates no longer putting off taking key steps to CECL adoption.
CECL also impacts accounting for off-balance-sheet credit exposure, held-to-maturity securities, and other financial assets measured at amortized cost. Although the impact related to the ALLL is most significant, these other items must also be considered.
The best was to ensure CECL adoption goes as smoothy as possible for your institution is to not wait any longer in developing and executing your institutions adoption plan and having regular and clear communications between management, those charged with governance, and your institution’s accountants.
How Wipfli can help
Our dedicated financial institutions team can help with CECL adoption or any other regulations. Learn more about our services on our financial institutions web page.