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FASB releases CECL: What you need to know now

06.27.16




On June 16th 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 Public Company Accounting Oversight Board (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.
     
    a. 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.
     
    b. 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.

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. To keep up to date, sign up here and receive our updates as they come out.

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