People are often classified as either an optimist or pessimist. I have found that when it comes to Accounting Standards Update No. 2016-13, Measurement of Credit Losses on Financial Instruments, better known as CECL (the Current Expected Credit Loss model), management of community institutions often falls into these two categories. The optimists believe there will be a carve-out of some sort that will exempt small institutions and allow them to use the “old model.” The pessimists believe their reserves will double and that an additional software package must be purchased just to comply with the standard. However, there is a third option: somewhere in the middle. At this point, all institutions will be required to comply with CECL, but implementation is scalable. Implementation is set for 2020 for SEC institutions and 2021 for non-SEC institutions. So the big question is, “What, if anything, should I be doing now?”
The calculation will still be separated, in large part, into two primary pieces: loans evaluated individually and loans evaluated collectively. There are not too many changes for loans evaluated individually. However, for loans evaluated collectively, an institution has various loss estimation methodologies to choose from, such as a loss rate analysis, vintage analysis, migration analysis, probability of default analysis, and discounted cash flows analysis. So which method is right for you? The classic accountant answer is, “It depends.” The methodology will vary from institution to institution and possibly from loan pool to loan pool within an institution.
Learning about the various methodologies will help management find answers to questions such as:
- What data do we need? This will likely include, at a minimum, origination/renewal dates and amounts, charge-off dates and amounts, risk ratings, and collateral codes.
- What can we leverage from our core system? Computer technology is extremely powerful and often taken for granted. Investigate what data can be captured, how it can be captured, and how it can be extracted for easy input to your model.
- Who should be involved with implementation? Chances are this will be more individuals than are currently involved. Your IT managers can assist with the answer to question #2. Loan officers and loan processors will be responsible for gathering data and entering it into the core. The accounting department will be posting journal entries. And let’s not forget, someone will need to actually prepare the calculation.
- What will the financial impact be? One thing everyone seems to agree on is that the allowance for loan losses balance will increase. But by how much? This will vary depending on the institution. Although the initial provision recorded at implementation will not impact earnings, it will impact capital. So as the final stages of Basel III are phased in and CECL is implemented, it is important to engage in proper capital planning.
We can all speculate on the impact as optimists or pessimists, or we can plan, test, and ultimately determine what the true impact will be. To learn more about CECL and what your institution should be doing now to prepare, we invite you to download our free webinar.