This past June the Federal Accounting Standards Board (FASB) released the Accounting Standards Update 2016-13 which is a major reform of how financial institutions calculate loss allowances for most of their financial assets. Under the standard, financial institutions and others will move away from the longstanding incurred loss model to a new model called Current Expected Credit Loss (CECL).
CECL is revolutionary by many accounts, placing tremendous new burdens on entities of every kind that extend credit and that report under the U.S. Generally Accepted Accounting Principles (GAAP) and requiring them to completely revamp their methodology and process for calculating losses.
Adopting an entirely new estimation of loss
Under CECL, these entities will have to adopt entirely new, forward-looking, lifetime estimations of Expected Loss on all obligations not specifically exempted from the new standard. In addition, and perhaps of even greater significance to banks, all calculations must be done with analytical consistency among both public and private companies, irrespective of the tremendous volumes of loans involved.
The stakes will be high for the banking industry as SEC registrants begin reporting under the new standard by 2019. While this may seem far off, such metamorphosis of process will take years of planning and preparation, starting now. Here are three steps banks and credit unions can take immediately to begin to transition towards CECL.
3 Steps to take now towards CECL preparedness
- Identify what exactly the financial institution needs to do to comply
The immediate imperative for many banking executives is to clarify how much of their present methodology will serve them in complying with CECL and what more they will need to develop themselves or obtain from third parties to meet the new requirements.
- Ensure efficacy and the ability to integrate new tools
As financial institutions identify their model-expansion needs, executives will have the ongoing imperative of subjecting new tools to rigorous validation not just of efficacy but also of consistency with previous modeling still in the bank’s employ.
- Establish Comprehensive Reporting to Operationalize Assessments
Bankers will likewise have to secure workflow solutions commensurate with CECL’s new demands for collecting, analyzing, reporting and storing their loan data.
CECL is an immediate concern, not a distant one
Well ahead of the deadlines, regulators expect to see serious planning groups – composed of accounting, credit, operations and regulatory personnel – in place throughout the industry in 2017. Auditors recommend banks run parallel systems of accounts for at least a year ahead of formal submissions to allow time for CECL’s radical adjustments. Responding to CECL is an immediate concern, not a distant one.
Federal bank regulators have called upon banks to build on existing credit risk management systems and processes. The Office of the Comptroller of the Currency (OCC) revealed in the Shared National Credits Reports, which examines the largest Commercial and Industrial credits shared by multiple financial institutions, that half of the $4.1 Trillion in commitments to 6,678 individual obligors mature in Years Four and Five. Unfortunately, few if any banks have models in place that reliably calculate PDs out that far. To address this need, Rapid Ratings will introduce a Term PD model in 1Q 2017 that leverages our Financial Health Ratings system on public and private companies across all industries globally.