By: Tommy Troyer, Executive Vice President
Those who have been following the Financial Accounting Standards Board’s (FASB) nearly decade-long effort to revamp the accounting rules impacting the recognition of impairment on financial assets (and thus how community banks determine the level of their ALLL) have heard for years that the project was nearing completion. While the project has indeed been moving forward over all these years, the anticipated date of finalization has been repeatedly pushed back. However, this time really is different: on April 27, FASB voted to direct FASB staff to prepare the final draft of the proposed update for a vote by written ballot. FASB hopes for the standard to be formally approved by June 30, but any delays beyond that point should be minimal as FASB has clearly reached a level of comfort with the current draft language.
The new approach to loss recognition is known as the CECL, or Current Expected Credit Loss, model. It represents a significant change to current practices, with the heart of the change being that the ALLL should cover expected lifetime losses on held-to-maturity loans and most other financial assets, rather than simply covering “probable” losses that are deemed to have been “incurred” as of the balance sheet date. In simplified terms, this means that the foundation of the ALLL estimate for community banks will not be an estimate of losses over the next year but will instead be an estimate of all losses expected over the life of the loans held on the balance sheet as of the date of the ALLL calculation. Additionally, the standard requires a forward-looking aspect, as institutions must consider the impact of “reasonable and supportable forecasts” on their loss estimates.
FASB also decided on April 27 to delay the implementation date of CECL by one year from the implementation dates originally determined in November. This means that CECL will need to be implemented in the first fiscal year following December 15, 2019 (2020 for banks with January-December fiscal years) for banks that are “SEC-filers,” and in the first fiscal year following December 15, 2020 (2021 for January-December fiscal years) for banks that are not “SEC-filers.” Early adoption beginning in the first fiscal year following December 15, 2018 (2019 for January-December fiscal years) is permitted.
The Balancing Act: Prepare, but Don’t Panic
The proper approach for any community bank is to attempt to find a balance between complacency about CECL and panic about CECL. Complacency about CECL (including believing that the extra year FASB provided before implementation means an additional year before a bank needs to start preparing) will lead to issues down the road. The methodology and data used to estimate the allowance under CECL will need to be meaningfully different from what banks use today, and as such, preparation to collect data and develop a methodology should begin now. Banks should understand that nearly all community banks base their current ALLL methodology on data that measures net charge-off rates on a monthly, quarterly, or annual basis. Such data does not describe lifetime loss rates, however, which is what is needed to comply with CECL’s lifetime expected loss standard. Thus, some basic data collection and evaluation efforts should begin now, in part to allow some time to accumulate the data needed by the implementation date.
At the same time that banks recognize the need to begin preparing, they need to also recognize that CECL does not represent any reason to panic. CECL will require some additional work for an effective transition, but it is not an existential threat to any community bank. We believe that some of the most extreme concerns discussed publicly in recent years about CECL and the complexity of approach it might require were overstated, given comments from FASB, financial regulators, and the wording of the 2012 draft Accounting Standards Update. All of these sources emphasized that the approach used by an institution should be appropriate for that institution’s size and complexity. However, the most recent draft released by FASB does represent a notable improvement in the clarity with which this fact is communicated: community banks will not be expected to use unduly complex or expensive approaches. Further, it seems that in every opportunity financial regulators have to speak about CECL, they emphasize that they intend to tailor their expectations for approaches to the size and complexity of financial institutions. Regulators have also repeatedly noted that they do not believe that a community bank will need to purchase an expensive software solution or vendor model in order to comply with CECL.
The Path Forward
At this point in time, banks have all of the information about CECL that they could need to develop a project plan for the transition. Such a plan should incorporate all relevant areas of the bank (for example, in many community banks the IT area will need to provide support with data gathering and warehousing), and updates on progress should regularly be provided to the board or a committee thereof. Evaluating the adequacy of existing credit risk data and planning to improve its collection and storage should be a high priority. Data should be collected in a way that allows institutions to measure lifetime losses and to understand the most important drivers of risk that impact loss rates.
Young & Associates, Inc. is closely following CECL and what it means for community banks. We have presented and will continue to present educational offerings on CECL through various state banking associations. We are also prepared to provide consulting services to help assist community banks in the preparation process. This can include helping banks understand the types of methodologies that can be acceptable means of estimating lifetime losses under CECL and the types of data that will be needed to support such methodologies.
To discuss CECL further, contact Tommy Troyer at 1.800.525.9775 or click here to send an email.