Is Your Bank Ready to Meet Cecil?

FASB proposes new model for accounting for loan losses

In the aftermath of the financial meltdown, accounting policy makers and professionals have been trying to understand why the losses inherent in banks’ loan portfolios did not capture the losses that were ultimately incurred in a timely manner. After much deliberation and several iterations, the Financial Accounting Standards Board (FASB) proposed a new model to account for loan losses, and it’s now time for financial institutions to start getting ready for the changes.

The proposed model introduces the concept of shifting from an incurred loss model to the current expected credit loss model commonly referred to as CECL (pronounced “Cecil”).  This shift would require banks to collect a significantly larger volume of data, including loan-level data (e.g., risk ratings, charge-offs, recoveries, historical balances) and other data (e.g., economic data, borrower financial data) that could be correlated to loan losses.

The CECL model has already gone through the exposure draft process, although it continues to be tweaked by the FASB in recent meetings. Despite the uncertainty that still surrounds the final model and expected long implementation period, financial institutions can use the time now to start assessing their IT investments and making plans to improve their data collection.

Many analysts and bankers who support the new model believe that the CECL model of allowance for loan and lease losses (ALLL) will more accurately and timely reflect loss within a bank’s portfolio.

The shift in approach to accounting for loan losses is expected to accelerate the recognition of loan reserves by removing the probable threshold for loan loss recognition that is a requirement in the current model. Instead, the CECL model requires financial institutions to estimate cash flows not expected to be collected over the life of the loan. Along with historical loss rates, the estimate should utilize probabilities of default, changes in portfolio risk and forecasting measures that are supportable. The CECL model also attempts to simplify the accounting guidance by creating essentially one model to record impairment within a bank’s loan portfolio, which currently utilizes multiple models.

Most observers agree that the currently proposed methodology will likely result in larger initial allowances that will be recognized sooner when compared to the existing model. In fact, many believe that this shift will likely require financial institutions to record a provision upon the origination of a loan. Additionally, banks will need to be prepared to obtain more granular loan portfolio data and verifiable forecast data to implement the CECL model.

As the CECL model is increasingly expected to be adopted, banks should begin to get familiar with these changes as the conversion to the new model will require extensive organizational planning. With the increased data requirements, the new model may be challenging for financial institutions to implement and could require increased investments in IT systems and staff.

Contact me or another member of our banking industry group to learn more about how the proposed CECL model could affect your financial institution and how we can help you prepare for the ALLL changes.