CECL adoption: Allowance analysis and where we are now

Do you know what would happen to your company if your CEO suddenly had to resign immediately for personal reasons? Or got seriously ill? Or worse, died? These scenarios, while rare, do happen, and many companies are not prepared. In fact, 45% of US companies do not have a contingency plan for CEO succession, according to a 2020 Harvard Business Review study.  

Do you have a plan for CEO succession? As a business owner, you may have an exit strategy in place for your company, but do you have a plan to bridge the leadership gap for you and each member of your leadership team? Does the plan include the kind of crises listed above? What would you do if your next-in-line left suddenly? 

Whether yours is a family-owned business, a company of equity partners, or a private company with a governing body, here are things to consider when you’re faced with a situation where your CEO has abruptly departed or has decided to step down.  

1. Get a plan in place. First, assess the situation and figure out your priorities. If there is already a plan for these types of circumstances, evaluate how much of it is applicable to this particular circumstance. For example, if the plan is for the stepping down or announced retirement of your CEO, but some other catastrophic event occurs, you may need to adjust key components and focus on immediate messaging rather than future positioning. If there is no plan, assign a small team to create one immediately. 

Make sure management, team leaders, and employees are aware and informed of your progress; this will help keep you organized and streamline communications. Management needs to take the lead and select a point person to document the process. Management also needs to take the lead in demeanor. Model your actions so employees can see the situation is being handled with care. Once a strategy is identified based on your priorities, draft a plan that includes what happens now, in the immediate future, and beyond. Include timetables so people know when decisions will be made.  

2. Communicate clearly, and often. In times of uncertainty, your employees will need as much specific information as you can give them. Knowing when they will hear from you, even if it is “we have nothing new to report” builds trust and keeps them vested and involved. By letting them know what your plan is, when they’ll receive another update, what to tell clients, and even what specifics you can give them (e.g., who will take over which CEO responsibility and for how long), you make them feel that they are important stakeholders, and not just bystanders. Stakeholders are more likely to be strong supporters during and after any transition that needs to take place. 

3. Pull in professional help. Depending on your resources, we recommend bringing in a professional to help you handle the situation at hand. At the very least, call in an objective opinion. You’ll need someone who can help you make decisions when emotions are running high. Bringing someone on board that can help you decipher what you have to work with and what your legal and other obligations may be, help rally your team, deal with the media, and manage emotions can be invaluable during a challenging time. Even if it’s temporary. 

4. Develop a timeline. Figure out how much time you have for the transition. For example, if your CEO is ill and will be stepping down in six months, you have time to update any existing exit strategy or succession plan you have in place. Things to include in the timeline: 

• Who is taking over what responsibilities? 
• How and what will be communicated to your company and stakeholders? 
• How and what will be communicated to the market? 
• How will you bring in the CEO's replacement, while helping the current CEO transition out of the organization? 

If you are in a crisis situation (e.g., your CEO has been suddenly forced out or asked to leave without a public explanation), you won’t have the luxury of time.  

Find out what other arrangements have been made in the past and update them as needed. Work with your PR firm to help with your change management and do the right things for all involved to salvage the company’s reputation. When handled correctly, crises don’t have to have a lasting negative impact on your business.   

5. Manage change effectively. When you’re under the gun to quickly make significant changes at the top, you need to understand how the changes may affect various parts of your company. While instinct may tell you to focus externally, don’t neglect your employees. Be as transparent as you possibly can be, present an action plan, ask for support, and get them involved in keeping the environment positive. Whether you bring in professionals or not, make sure you allow for questions, feedback, and even discord if challenging information is being revealed.  

6. Handle the media. Crisis rule #1 is making it clear who can, and who cannot, speak to the media. Assign a point person for all external inquiries and instruct employees to refer all reporter requests for comment to that point person. You absolutely do not want employees leaking sensitive information to the media. 
 
With your employees on board with the change management action plan, you can now focus on external communications and how you will present what is happening to the media. This is not completely under your control. Technology and social media changed the game in terms of speed and access to information to the public and transparency when it comes to corporate leadership. Present a message to the media quickly that coincides with your values as a company. If you are dealing with a scandal where public trust is involved and your CEO is stepping down, handling this effectively will take tact and most likely a team of professionals to help. 

Exit strategies are planning tools. Uncontrollable events occur and we don’t always get to follow our plan as we would have liked. Your organization can still be prepared and know what to do in an emergency situation or sudden crisis.  Executives move out of their roles every day, but how companies respond to these changes is reflective of the strategy in place to handle unexpected situations. Be as prepared as possible. Own your challenges. Stay accountable. 

BerryDunn can help whether you need extra assistance in your office during peak times or interim leadership support during periods of transition. We offer the expertise of a fully staffed accounting department for short-term assignments or long-term engagements―so you can focus on your business. Meet our interim assistance experts.

It’s one thing for coaching staff to see the need for a new quarterback or pitcher. Selecting and onboarding this talent is a whole new ballgame. Various questions have to be answered before moving forward: How much can we afford? Are they a right fit for the team and its playing style? Do the owners approve?

Management has to answer similar questions when selecting and implementing a cybersecurity maturity model, and form the basis of this blog – chapter 2 in BerryDunn’s Cybersecurity Playbook for Management.

What are the main factors a manager should consider when selecting a maturity model?
RG: All stakeholders, including managment, should be able to easily understand the model. It should be affordable for your organization to implement, and its outcomes achievable. It has to be flexible. And it has to match your industry. It doesn’t make a lot of sense to have an IT-centric maturity model if you’re not an extremely high-tech organization. What are you and your organization trying to accomplish by implementing maturity modeling? If you are trying to improve the confidentiality of data in your organization’s systems, then the maturity model you select should have a data confidentiality domain or subject area.

Managers should reach out to their peer groups to see which maturity models industry partners and associates use successfully. For example, Municipality A might look at what Municipality B is doing, and think: “How is Municipality B effectively managing cybersecurity for less money than we are?” Hint: there’s a good chance they’re using an effective maturity model. Therefore, Municipality A should probably select and implement that model. But you also have to be realistic, and know certain other factors—such as location and the ability to acquire talent—play a role in effective and affordable cybersecurity. If you’re a small town, you can’t compare yourself to a state capital.

There’s also the option of simply using the Cybersecurity Capability Maturity Model (C2M2), correct?
RG: Right. C2M2, developed by the U.S. Department of Energy, is easily scalable and can be tailored to meet specific needs. It also has a Risk Management domain to help ensure that an organization’s cybersecurity strategy supports its enterprise risk management strategy.

Once a manager has identified a maturity model that best fits their business or organization, how do they implement it?
RG: STEP ONE: get executive-level buy-in. It’s critical that executive management understands why maturity modeling is crucial to an organization's security. Explain to them how maturity modeling will help ensure the organization is spending money correctly and appropriately on cybersecurity. By sponsoring the effort, providing adequate resources, and accepting the final results, executive management plays a critical role in the process. In turn, you need to listen to executive management to know their priorities, issues, and resource constraints. When facilitating maturity modeling, don’t drive toward a predefined outcome. Understand what executive management is comfortable implementing—and what the business or organization can afford.

STEP TWO: Identify leads who are responsible for each domain or subject area of the maturity model. Explain to these leads why the organization is implementing maturity modeling, expected outcomes, and how their input is invaluable to the effort’s success. Generally speaking, the leads responsible for subject areas are very receptive to maturity modeling, because—unlike an audit—a maturity model is a resource that allows staff to advocate their needs and to say: “These are the resources I need to achieve effective cybersecurity.”

Third, have either management or these subject area leads communicate the project details to the lower levels of the organization, and solicit feedback, because staff at these levels often have unique insight on how best to manage the details.

The fourth step is to just get to work. This work will look a little different from one organization to another, because every organization has its own processes, but overall you need to run the maturity model—that is, use the model to assess the organization and discover where it measures up for each subject area or domain. Afterwards, conduct work sessions, collect suggestions and recommendations for reaching specific maturity levels, determine what it’s going to cost to increase maturity, get approval from executive management to spend the money to make the necessary changes, and create a Plan of Action and Milestones (POA&M). Then move forward and tick off each milestone.

Do you suggest selecting an executive sponsor or an executive steering committee to oversee the implementation?
RG: Absolutely. You just want to make sure the executive sponsors or steering committee members have both the ability and the authority to implement changes necessary for the modeling effort.

Should management consider hiring vendors to help implement their cybersecurity maturity models?
RG: Sure. Most organizations can implement a maturity model on their own, but the good thing about hiring a vendor is that a vendor brings objectivity to the process. Within your organization, you’re probably going to find erroneous assumptions, differing opinions about what needs to be improved, and bias regarding who is responsible for the improvements. An objective third party can help navigate these assumptions, opinions, and biases. Just be aware some vendors will push their own maturity models, because their models require or suggest organizations buy the vendors’ software. While most vendor software is excellent for improving maturity, you want to make sure the model you’re using fits your business objectives and is affordable. Don’t lose sight of that.

How long does it normally take to implement a maturity model?

RG: It depends on a variety of factors and is different for every organization. Keep in mind some maturity levels are fairly easy to reach, while others are harder and more expensive. It goes without saying that well-managed organizations implement maturity models more rapidly than poorly managed organizations.

What should management do after implementation?
RG: Run the maturity model again, and see where the organization currently measures up for each subject area or domain. Do you need to conduct a maturity model assessment every year? No, but you want to make sure you’re tracking the results year over year in order to make sure improvements are occurring. My suggestion is to conduct a maturity model assessment every three years.

One final note: make sure to maintain the effort. If you’re going to spend time and money implementing a maturity model, then make the changes, and continue to reassess maturity levels. Make sure the process becomes part of your organizations’ overall strategic plan. Document and institutionalize maturity modeling. Otherwise, the organization is in danger of losing this knowledge when the people who spearheaded the effort retire or pursue new opportunities elsewhere.

What’s next?
RG: Over the next couple of blogs, we’ll move away from talking about maturity modeling and begin talking about the role capacity plays in cybersecurity. Blog #3 will instruct managers on how to conduct an internal assessment to determine if their organizations have the people, processes, and technologies they need for effective cybersecurity.

Read our next cybersecurity playbook article, Tapping your internal capacity for better results: Cybersecurity playbook for management #3, here.

For professional baseball players who get paid millions to swing a bat, going through a slump is daunting. The mere thought of a slump conjures up frustration, anxiety and humiliation, and in extreme cases, the possibility of job loss.

The concept of a slump transcends sports. Just glance at the recent headlines about Yahoo, Equifax, Deloitte, and the Democratic National Committee. Data breaches occur on a regular basis. Like a baseball team experiencing a downswing, these organizations need to make adjustments, tough decisions, and major changes. Most importantly, they need to realize that cybersecurity is no longer the exclusive domain of Chief Information Security Officers and IT departments. Cybersecurity is the responsibility of all employees and managers: it takes a team.

When a cybersecurity breach occurs, people tend to focus on what goes wrong at the technical level. They often fail to see that cybersecurity begins at the strategic level. With this in mind, I am writing a blog series to outline the activities managers need to take to properly oversee cybersecurity, and remind readers that good cybersecurity takes a top-down approach. Consider the series a cybersecurity playbook for management. This Q&A blog — chapter 1 — highlights a basic concept of maturity modeling.

Let’s start with the basics. What exactly is a maturity model?
RG: A maturity model is a framework that assesses certain elements in an organization, and provides direction to improve these elements. There are project management, quality management, and cybersecurity maturity models.

Cybersecurity maturity modeling is used to set a cybersecurity target for management. It’s like creating and following an individual development program. It provides definitive steps to take to reach a maturity level that you’re comfortable with — both from a staffing perspective, and from a financial perspective. It’s a logical road map to make a business or organization more secure.

What are some well-known maturity models that agencies and companies use?
RG: One of the first, and most popular is the Program Review for Information Security Management Assistance (PRISMA), still in use today. Another is the Capability Maturity Model Integration (CMMI) model, which focuses on technology. Then there are some commercial maturity models, such as the Gartner Maturity Model, that organizations can pay to use.

The model I prefer is the Cybersecurity Capability Maturity Model (C2M2), developed by the U.S. Department of Energy. I like C2M2 because it directly maps to the U.S. Department of Commerce’s National Institute of Standards and Technology (NIST) compliance, which is a prominent industry standard. C2M2 is easily understandable and digestible, it scales to the size of the organization, and it is constantly updated to reflect the most recent U.S. government standards. So, it’s relevant to today’s operational environment.

Communication is one of C2M2’s strengths. Because there is a mechanism in the model requiring management to engage and support the technical staff, it facilitates communication and feedback at not just the operational level, but at the tactical level, and more significantly, the management level, where well-designed security programs start.

What’s the difference between processed-based and capability-based models?
RG: Processed-based models focus on performance or technical aspects — for example, how mature are processes for access controls? Capability-based models focus on management aspects — is management adequately training people to manage access controls?

C2M2 combines the two approaches. It provides practical steps your organization can take, both operationally and strategically. Not only does it provide the technical team with direction on what to do on a daily basis to help ensure cybersecurity, it also provides management with direction to help ensure that strategic goals are achieved.

Looking at the bigger picture, what does an organization look like from a managerial point of view?
RG: First, a mature organization communicates effectively. Management knows what is going on in their environment.

Most of them have very competent staff. However, staff members don’t always coordinate with others. I once did some security work for a company that had an insider threat. The insider threat was detected and dismissed from the company, but management didn’t know the details of why or how the situation occurred. Had there been an incident response plan in place (one of the dimensions C2M2 measures) — or even some degree of cybersecurity maturity in the company, they would’ve had clearly defined steps to take to handle the insider threat, and management would have been aware from an early stage. When management did find out about the insider threat, it became a much bigger issue than it had to be, and wasted time and resources. At the same time, the insider threat exposed the company to a high degree of risk. Because upper management was unaware, they were unable to make a strategic decision on how to act or react to the threat.

That’s the beauty of C2M2. It takes into account the responsibilities of both technical staff and management, and has a built-in communication plan that enables the team to work proactively instead of reactively, and shares cybersecurity initiatives between both management and technical staff.

Second, management in a mature organization knows they can’t protect everything in the environment — but they have a keen awareness of what is really important. Maturity modeling forces management to look at operations and identify what is critical and what really needs to be protected. Once management knows what is important, they can better align resources to meet particular challenges.

Third, in a mature organization, management knows they have a vital role to play in supporting the staff who address the day-to-day operational and technical tasks that ultimately support the organization’s cybersecurity strategy.

What types of businesses, not-for-profits, and government agencies should practice maturity modeling?
RG: All of them. I’ve been in this industry a long time, and I always hear people say: “We’re too small; no one would take any interest in us.”

I conducted some work for a four-person firm that had been hired by the U.S. military. My company discovered that the firm had a breach and the four of them couldn’t believe it because they thought they were too small to be breached. It doesn’t matter what the size of your company is: if you have something someone finds very valuable, they’re going to try to steal it. Even very small companies should use cybersecurity models to reduce risk and help focus their limited resources on what is truly important. That’s maturity modeling: reducing risk by using approaches that make the most sense for your organization.

What’s management’s big takeaway?
RG: Cybersecurity maturity modeling aligns your assets with your funding and resources. One of the most difficult challenges for every organization is finding and retaining experienced security talent. Because maturity modeling outlines what expertise is needed where, it can help match the right talent to roles that meet the established goals.

So what’s next?
RG: In our next installment, we’ll analyze what a successful maturity modeling effort looks like. We’ll discuss the approach, what the outcome should be, and who should be involved in the process. We’ll discuss internal and external cybersecurity assessments, and incident response and recovery.

You can read our next chapter, Selecting and implementing a maturity model: Cybersecurity playbook for management #2, here.

On June 16^th the FASB issued the final standard for credit losses. We’ve analyzed the new standard and pulled together some key items you’ll need to know:

It looks like you should be able to implement CECL without purchasing expensive third-party models, if your institution is able to get adequate historical data from your core system and has the personnel available to crunch the numbers. Following is one approach that should pass muster with regulators (and, hopefully, the PCAOB):

1. Determine loans for which specific reserves are appropriate, much as you are currently doing. The notion of “impaired” loans goes away; a loan should be evaluated specifically if the institution becomes aware of loan-specific information indicating it has an exposure to loss that differs from other loans it would otherwise be pooled with. In practice, we think that’ll be largely the same loans that are currently being identified as impaired.
2. For the rest of the portfolio: Group loans by common characteristics – same as you’re doing now.
   1. For each group, create subgroups for each origination year. It looks like current year and previous four years are the critical ones to focus on; anything older than five years could probably be lumped together.
   2. For each subgroup, establish economic and other relevant conditions for the average term of loans in the subgroup. This includes actual conditions from year of origination to the present, forecasted conditions for the near future, and long-term historical conditions for the remaining average loan term
      • Select an historical loss period that best approximates the conditions established in (b) above.
      • Determine average lifetime chargeoffs for that historical loss period for each loan type
      • Adjust that average for any current or expected conditions that you believe are different from this historical data.  Such adjustments should be based on the institution’s chargeoff experience when similar conditions occurred in the past.  An example might be an actual or expected decline in real estate values that you believe is more pronounced than in the historical loss period chosen.

While not specifically mentioned in the guidance, we believe a modest unallocated allowance is still supportable, especially since imprecision is certainly higher when factoring in expected losses in addition to incurred losses.
 

Other points that caught our eye:

1. The guidance applies to purchased loans with credit deterioration, as well as originated loans. That will create more comparability in terms of the allowance as a % of loans for institutions that have done acquisitions vs. those who haven’t. An interesting twist, though – for acquired loans that have experienced a more-than-insignificant deterioration in credit quality since origination, the allowance established is simply an adjustment to (ultimately) the premium or discount, while for other loans acquired in the transaction, an allowance is established with an offset to loan loss expense at acquisition. 
2. The guidance applies to held-to-maturity debt securities, and there’s specific guidance that affects the accounting for available-for-sale debt securities as well. These will likely only come into play for institutions with private-label mortgage-backed securities and/or corporate bonds. However, some of the CECL disclosure requirements apply to securities as well; in particular, the one that caught our eye was the requirement in ASC 326-20-50-5 to disclose credit quality indicators (e.g., S&P ratings) for securities as well as loans.
3. Surprisingly, you continue to assume no change in future interest rates for purposes of establishing expected credit losses for specific variable rate loans. We think FASB may have missed the boat on this one, as resetting ARMs were one of the factors that led to the 2008 crisis that CECL is intended to be responsive to.
4. There will obviously be much, much more dialogue about these new rules, and we’ll need to begin the process of helping you understand them and prepare for implementation sooner rather than later.

Please call us if you have any questions.

When last we blogged about the Financial Accounting Standards Board’s (FASB) new “current expected credit losses” (CECL) model for estimating an allowance for loan and lease losses (ALLL), we reviewed the process for developing reasonable and supportable forecasts for use in establishing the ALLL. Once you develop those forecasts, how does that information translate into amounts to set aside for loan losses?

A portion of the ALLL will continue to be based on specifically identified loans you’re concerned about. For those loans, you will continue to establish a specific component of the ALLL based on your estimate of the loss ultimately expected on the loans.

The tricky part, of course, is estimating an ALLL for the other 99% of the loan portfolio. This is where the forecasts come in. The new rules do not prescribe a particular methodology, and banking regulators have indicated community banks will likely be able to continue with their current approach, adjusted to use appropriate inputs in a manner that complies with the CECL model. One of the biggest challenges is the expectation in CECL that the ALLL will be estimated using the institution’s historical information, to the extent available and relevant.

Following is just one of many ways  you can approach it. I’ve also included a link at the end of this article to an example illustrating this approach.

Step One: Historical Loss Factors

1. First, for a given subset of the loan portfolio (e.g., the residential loan pool), you might first break down the portfolio by the number of years remaining until expected payoff (via maturity or refinancing). This is important because, on average, a loan with seven years remaining until expected payoff will have a higher level of remaining lifetime losses than a loan with one year remaining. It therefore generally wouldn’t be appropriate to use the same loss factor for both loans.
    
2. Next, decide on a set of drivers that tend to correlate with loan losses over time. FASB has indicated it doesn’t expect highly mathematical correlation models will be necessary, especially for community banks. Instead, select factors in your bank’s experience indicative of future losses. These may include:
   • External factors, such as GDP growth, unemployment rates, and housing prices
   • Internal factors such as delinquency rates, classified asset ratios, and the percentage of loans in the portfolio for which certain policy exceptions (e.g., loan-to-value ratio or minimum credit score) were granted
      
3. Once you select this set of drivers, find an historical loss period — a period of years corresponding to the estimated remaining life of the portfolio in question — where the historical drivers best approximate those you’re expecting in the future, based on your forecasts. For that historical loss period, determine the lifetime remaining loss rates of the loans outstanding at the beginning of that period, broken down by the number of years remaining until payoff. (This may require significant data mining, especially if that historical loss period was quite a few years ago.
    
4. Apply those loss rates to the breakdown derived in (a) above, by years remaining until maturity.

   Step Two: Adjustments to Historical Loss Rates

   The CECL model requires we adjust historical loss factors for conditions that may not be adequately captured by the historical loss period analysis we’ve just described. Let’s say a particular geographical subset of your market area is significantly affected by the economic fortunes of a large employer in that area.  Based on economic trends or recent developments, you might expect that employer to have a particularly bright – or dim – future over the forecast period; accordingly, you forecast loans to borrowers in that area will have losses that differ significantly from the rest of the portfolio.

   The approach for these loans is the same as in the previous step. However:

   These loans would be segregated from the remainder of the portfolio, which would be subject to the general approach in step one. As you think through this approach, there are myriad variations and many decisions to make, such as:

   Our intent in describing this methodology is to help your CECL implementation team start the dialogue in terms of converting theoretical concepts in the CECL model to actual loans and historical experience.

   To facilitate that discussion, we’ve included a very simple example here that illustrates the steps described above. Analyzing an entire loan portfolio under the CECL model is an exponentially more complex process, but the concepts are the same — forecasting future conditions, and establishing an ALLL based on the bank’s (or, when necessary, peers’) lifetime loan loss experience under similar historical conditions.

   Given the amount of number crunching and analysis necessary, and the potentially significant increase in the ALLL that may result from a lifetime-of-loan loss model, it’s safe to say the time to start is now! If you have any questions about CECL implementation, please contact Tracy Harding or Rob Smalley.

   Other resources
   For more information on CECL, check out our other blogs:

   CECL: Where to Start
   CECL: Bank and Branch Acquisitions
   CECL: Reasonable and Supportable

   To sign up to receive notification of our next CECL update, click here.

   • In substep (c), you would focus on forecasted conditions (such as unemployment rate and changes in real estate values) in the geographical area in which the significant employer is located.
   • You would then select an historical loss period that had actual conditions for that area that best correspond to those you’ve just forecasted.
   • In substep (d), you would determine the lifetime remaining loss rates of loans outstanding at the beginning of that period.
   • In substep (e), you would apply those rates to loans in that geographic area.
   • How to break down the portfolio
   • Which conditions to analyze
   • How to analyze the conditions for correlation with historical loss periods
   • Which resulting loss factors to apply to which loans

Recently, federal banking regulators released an interagency financial institution letter on CECL, in the form of a Q&A. Read it here. While there weren’t a lot of new insights into expectations examiners may have upon adoption, here is what we gleaned, and what you need to know, from the letter.

ALLL Documentation: More is better

Your management will be required to develop reasonable and supportable forecasts to determine an appropriate estimate for their allowance for loan and lease losses (ALLL). Institutions have always worked under the rule that accounting estimates need to be supported by evidence. Everyone knows both examiners and auditors LOVE documentation, but how much is necessary to prove whether the new CECL estimate is reasonable and supportable? The best answer I can give you is “more”.

And regardless of the exact model institutions develop, there will be significantly more decision points required with CECL than with the incurred loss model. At each point, both your management and your auditors will need to ask, “Why this path vs. another?” Defining those decision points and developing a process for documenting the path taken while also exploring alternatives is essential to build a model that estimates losses under both the letter and the spirit of the new rules. This is especially true when developing forecasts. We know you are not fortune tellers. Neither are we.

The challenge will be to document the sources used for forecasts, making the connections between that information and its effect on your loss data as clear as possible, so the model bases the loss estimate on your institution’s historical experience under conditions similar to those you’re forecasting, to the extent possible.

Software may make this easier… or harder.               

The leading allowance software applications allow for virtually instantaneous switching between different models, permitting users to test various assumptions in a painless environment. These applications feature collection points that enable users to document the basis for their decisions that become part of the final ALLL package. Take care to try and ensure that the support collected matches the decisions made and assumptions used.

Whether you use software or not there is a common set of essential controls to help ensure your ALLL calculation is supported. They are:

• Documented review and recalculation of the ALLL estimate by a qualified individual(s) independent of the preparation of the calculation
• Control over reports and spreadsheets that include data that feed into the overall calculation
• Documentation supporting qualitative factors, including reasonableness of the resulting reserve amounts
• Controls over loan ratings if they are a factor in your model
• Controls over the timeliness of charge-offs

In the process of implementing the new CECL guidance it can be easy to focus all of your effort on the details of creating models, collecting data and getting to a reasonable number. Based on the regulators’ new Q&A document, you’ll also want to spend some time making sure the ALLL number is supportable.  

Next time, we’ll look at a lesser known section of the CECL guidance that could have a significantly negative impact on the size of the ALLL and capital as a result: off-balance-sheet credit exposures.

By now, pretty much everyone in the banking industry has heard plenty of talk about CECL – the forthcoming “Current Expected Credit Loss” model of accounting for an institution’s allowance for loan losses (ALL). While the previous “Incurred Loss” model has been problematic to implement conceptually, and most of us thought CECL would improve ALL accounting and make it more comparable to how banks account for other debt instruments, it’s beginning to feel a bit like the dog who caught the car – now that we have this model, how the heck do we implement it?

The good news: We have a number of years before CECL’s effective date, and thus have some time to better understand the new rules and how to adapt an institution’s ALL model to reflect them. The bad news – the banking regulators recently announced they want banks to get cracking on this, and will expect to see some progress when they visit during upcoming exams – maybe not immediately, but likely at some point during the 2017 exam cycle.

This is the third in a series of articles addressing various aspects of this complex pronouncement. We hope that they provide you with practical advice that can help you get started on the nuts and bolts of CECL implementation.

Our previous article offered pointers on building the CECL team, brainstorming the process, and starting the data gathering conversation. In this article, we look at how to implement CECL when acquiring another bank, one or more branches of another bank, or simply a loan portfolio, such as a group of auto or credit card loans.

First, let’s remember the basics

The basic premise of CECL is that lifetime expected losses are to be booked at origination (or, in the case of an acquisition, at the acquisition date). You’ve likely heard some gnashing of teeth over the fact that this means losses are recorded “on Day One”, which many of us have some degree of conceptual difficulty with: For example, a higher risk loan will likely carry a higher yield at origination, so booking a higher level of expected losses on Day One (through the ALL) and the offsetting higher yield over the loan term (through interest income) feels like a mismatch between income and expense.

The Financial Accounting Standards Board (FASB) was sympathetic to this point, and spent a lot of time pondering it. Its international equivalent, the International Accounting Standards Board (IASB), which establishes – you guessed it – international accounting standards, actually tackled this issue by precluding Day One losses, unless they were expected to materialize within one year of origination (Day 365 losses?).

This approach, however, has led to a fairly convoluted – and challenging – model, which is already drawing a fair amount of criticism in the international community. In the end, although they had hoped to have a “converged” standard that would result in the same approach for U.S. and international institutions, FASB and the IASB decided to part company and use different models.

The short answer? We have to accept the notion of Day One losses as the price to pay for a less convoluted (but still complex to implement) model. This becomes important to remember as we look at accounting for acquisitions.

Accounting for acquisitions

Whether you’re acquiring a pool of loans, a branch, or an entire institution, the basic accounting under CECL is the same, and it’s the same (with a twist) as the accounting for originated loans: an ALL should be established for the purchase price allocated to the loans, and that ALL should reflect management’s estimate of the lifetime losses in the acquired portfolio.

Before we get into the details of how to do this, let’s take a moment to celebrate. Prior to CECL, it was not permissible to establish an initial ALL for acquired loans. Many bankers – and investors – complained that this made it difficult to compare one bank to another on metrics such as ALL coverage ratios. If one bank had a strategy that included acquisitions, and another didn’t, their ALLs would likely be quite different even if their loan portfolios and estimated incurred losses were similar. Now, with the CECL model, these two banks’ financial statements are much easier to compare.

As noted above, an ALL should be established for these loans under CECL, using the same methodology you would use for originated loans. The twist relates to what to do with the other side of the entry. The solution:

• For loans with a more-than-insignificant amount of credit deterioration since origination, the offset is to add this amount to the amount originally recorded for the purchase price allocated to the loans.

• For the rest of the acquired portfolio, the offset is to loan loss expense. That’s right, your provision is increased by the amount of ALL recorded in the transaction, except as noted in the previous bullet.

Why is this so? FASB is apparently assuming that:

• Buyers adjust the purchase price for the first item above. These loans, which we used to call “purchased – credit impaired (PCI)”, and now will call “purchased – credit deteriorated (PCD)” under CECL, are the loans with hair on them. They probably got some extra scrutiny during due diligence, thus theoretically depressing the purchase price a bit. Therefore, the amount of the purchase price allocated to loans is a lower number, and offsetting the establishment of the ALL by adding that amount to the purchase price assigned to the loans properly “grosses up” the recorded loan balance.

• Buyers don’t adjust the purchase price for other loans. This is probably true, as the lifetime losses on loans that aren’t PCD are just the cost of doing business for financial institutions. Therefore, as it is with originated loans, a big Day One provision is booked at closing.

It should be noted that the extent to which the definition of PCD loans differs from the previous definition of PCI loans depends on your interpretation of the old PCI definition. It appears clear that the new definition of PCD loans refers to loans that have specific indicators of significant credit deterioration since origination.

Let’s look at an example:

A bank buys three branches from another bank, which have total loans with a principal balance of $20 million and a fair value of $20,100,000. The portfolio includes loans with a principal balance of $1 million, and a fair value of $910,000, that are PCD.

The buyer bank determines the ALL under CECL would be $100,000 for the PCD loans and $475,000 for the rest of the acquired portfolio. Thus, the buyer bank records an ALL of $575,000. What’s the offset? As noted above:

• For the PCD loans, the offsetting $100,000 will be added to the $910,000 of purchase price allocated to those loans. As a result, these loans will have a gross amount allocated of $910,000 plus $100,000, or $1,010,000, which will then be reduced by an ALL of $100,000 on the balance sheet, for a net reported amount of $910,000 (their fair value). The difference between the gross amount assigned ($1,010,000) and the principal balance ($1 million), or $10,000, represents an implied adjustment to reflect current market interest rates, and is therefore amortized over the expected loan term through interest income.

• For the rest, the offsetting $475,000 will be an increase to the provision for loan losses, and will thus reduce income.

The last number could be a big one for institutions that do large or frequent acquisitions; thus, their balance sheets may be more comparable to other banks, but their income statements in the year of acquisition won’t be! The good news – like other acquisition costs such as legal fees and conversion expenses, this amount will be separately disclosed, so a reader can adjust for it if they believe it’s appropriate to do so.

Next time, we’ll look at the nuts and bolts of CECL’s concept of “reasonable and supportable” by considering proper documentation and controls over the ALL.