The Current Expected Credit Loss (CECL) standards are new accounting methods issued for recognition of credit losses for both loans and investments. The change will impact all financial institutions, because it will require up-front recognition of expected credit losses. The standard will be implemented in 2020 and 2021, depending on your structure. Early adoption is permitted in 2017. In the past year, we have spent considerable time with clients, audit firms and regulators discussing new standard and implications. This update provides a brief introduction to CECL and some preliminary steps to help you prepare for implementation.
Current allowance accounting standards are based on what has already happened related to loan losses or impairment. These principles have been in effect for nearly 40 years and are considered incurred-loss accounting. The analysis relates to historical annualized charge off ratios. In contrast, CECL is based on expected future losses. We would all like to believe that no loan will fail, but we know that some will. Under CECL, loan losses have not yet occurred. Instead, future losses are assumed and the amounts are estimated into the future. Projected losses are recorded upon origination. In addition, loss estimates under CECL are not annual rates, but are estimated total losses over the expected remaining life of the loan pool. The new standard is substantially different from current practices.
The new standard will be effective in 2020 for SEC-registered companies and 2021 for all others. That seems like a lot of time, but there is still plenty to do in advance as described below.
Estimating CECL starts with a detailed analysis of historical loan-level attributes. We have learned that some of the data is probably not being currently maintained. The good news is that implementation is a few years away. Although the required information may differ based on your unique business model, it is important to start collecting and saving information now. There is no such thing as having too much data. Also, it is important that the data is easy to use and analyze. We can always ignore what we do not need, but it may be impossible or expensive to retrieve information at a later date. Data needs fall into three broad categories:
Loan-Level Details: The first data set we need to track is unique data sets that will help us predict the possibility of a loan defaulting. This data needs to be easy to sort and use to enable you to predict the potential of future defaults. Effectively, these data points will be helpful as we analyze the factors leading up to a loss. Please see our 2016 Q4 update to see a sample data list.
Loss Severity: The second point of data we need to collect is to determine the severity of loan losses. When losses do occur, it will be important to retain as much information as possible about severity, timing and recoveries. As we move forward, we need to predict the severity of losses by loan type and other metrics.
Economic Conditions: Estimating future losses will require a forecast of future economic conditions. It will also be important to consider economic conditions that existed when past losses occurred, and economic position when loans are written. Key indicators include the unemployment rate, interest rate environment, housing values, commercial occupancy rates or other factors that may be unique to you. The good news here is that McQueen’s model is tracking this information for our clients. The trends will be important as we relate economic conditions to losses. In addition, expected economic conditions will used to support estimated future losses.
What Steps Should You Be Taking Today?
Although there is quite a bit of time before implementation, we think that it is important to consider several key points:
- Keep your management team and Board informed about CECL.
- Discuss CECL with your core processing system, and any potential new processing systems.
- Ensure that you are saving loan-level data now.
- The data you save needs to be useable (sortable and modelable).
What Steps Should You Not Be Taking Today?
We have seen a handful of companies selling solutions. This seems premature to us because the new standard is subject to interpretation, and implementation is many years away. Additionally, a significant amount of what we need to track is in your core processing system. There will be competition to fulfill this need.
This is not a belief that nothing should be done, but rather a view that you should use caution in purchasing a solution today.
This CECL overview certainly does not cover everything. Going forward, we want you to know that McQueen Financial is working on a model that will address your CECL needs. We will be hosting upcoming webinars and, as always, we are available to discuss your specific needs and to answer any questions you may have.