The clock is ticking down to what many in the industry are calling the “biggest change ever to bank accounting”, otherwise known as the Current Expected Credit Loss (CECL) calculations. The new requirements, which take effect in 2020 for SEC-registered banks, and 2021 for other institutions, will introduce fundamental changes, including:
- Adherence to a new calculation method for Allowance for Loan and Lease Losses (ALLL).
- Increased need for granular data production pertaining to qualitative and performance metrics.
- Inherent cost behind full preparation and execution of an ALLL audit.
CECL, the first major change since the introduction of backward-looking credit loss account standards 40 years ago, leverages an expected loss model that requires banks to look forward. It’s not based on annual loss rates but on life-of-loan or life-of-portfolio loss rates. The fundamental difference between the two approaches is that, while incurred loss accounting reflects current losses in a portfolio, CECL identifies current risk, encompassing both current and future credit losses.
Without question, CECL will have a direct impact on how banks manage their capital. So where do financial institutions go from here to prepare, and why is tight alignment between risk and finance more important than ever?
New complexity and questions
CECL will introduce new complexity and costs on several fronts. In most cases, CECL allowances will be higher than ALLL levels, intensifying capital and liquidity constraints. In addition, banks will require more granular data and expanded analytics capabilities, and face an increased burden of defending calculation models. Financial institutions also must further integrate risk and finance operations so that data from capital management, budgets and asset & liability management, are available for CECL calculations.
CECL doesn’t prescribe a single method for estimating credit losses. While banks can leverage various measurement approaches to determine impairment allowance, these models must include information about past events, current conditions and supportable forecasts about future economic events and conditions. By not mandating a specific calculation methodology, CECL introduces greater ambiguity, risk and uncertainty, as banks face a higher bar for defending their models and data.
With CECL, banks most proficient at accurately calculating and monitoring loss expectations are better prepared to optimise risk, pricing, capital and profitability. As such, the ability to fully integrate risk and finance data and operations has never been more important. While many institutions have started this journey, most remain in the early stages, placing them at a disadvantage as CECL deadlines loom.
Flexibility is invaluable
Flexibility is key as banks prepare for CECL. A single model won’t suffice for all financial instruments. Banks should be prepared to go deep. Granular data – and the ability to analyse and act on it – has never been more critical. Banks will even need to break down and analyse a portfolio’s individual loans by issuance year.
As a result, firms will need accurate and up to date data on prepayments, average life of a portfolio, as well as write-offs at certain points in a loan life cycle. Prepayments in particular will introduce new challenges, as they must be factored into the life of the loan. Banks, therefore, will now have to integrate the timing of anticipated charge-offs with prepayments.
So where does compliance start for financial institutions? As banks continue to look forward to a CECL-focused world of bank accounting, we’re able to boil down the regulation’s impact to three key areas: data, models and processes.
Data – Banks will require access to new types of data for longer periods of time than before for CECL calculation. The first is life of loan, which is the fundamental difference between CECL and incurred loss. Most organisations, however, don’t capture origination data, which will be vital in CECL calculations. They will also need to accurately predict the life of each loan, accounting for economic conditions and demographic factors. In other words, life of loan becomes a new risk factor.
Banks should prepare for a significant overhaul in disclosures. They’ll have to provide credit quality indicators by vintage for a minimum of five annual reporting periods. Given this high volume of required indicators, banks must consider tracking and maintaining individual cash flows for certain kinds of loans, such as corporate lines of credit for forecasting future draws.
Without question, CECL will be a more data-intensive process than banks have endured in the past. To ensure effective and efficient calculation, they need to capture their data and perform analysis from an enterprise level in an efficient, time-effective manner.
With CECL, risk and finance have to agree on, and fully understand, assumptions if they are to satisfy regulators and a higher level of scrutiny. It all starts with data, which largely remains fragmented.
Models – Under CECL, banks must maintain all credit loss provisioning by segments, including similar risk-based characteristics. They’ll have to aggregate credit risk at the group level rather than the individual instrument level. This intrinsically drives the need for new models to assess risk-based characteristics for segments and sub-segments.
There’s no single prescriptive model under CECL. Understanding the expected lifespan of an instrument (and its behaviour at various points in that life cycle) is critical to accurately factoring CECL calculations to avoid unnecessary strain on capital allocation.
Processes – A financial institution can have the most accurate and integrated data and the best models, but without complementary processes in place to support CECL, success remains an open-ended question. For example, because loan originations under CECL will create immediate accounting events – such as loss expectations – banks should consider new processes to ensure that factors underlying loss expectations are appropriately identified and tracked.
Now is a strategic time for institutions to assess their progress in the journey to unite risk and finance and identify the data and system requirements needed to ensure an effective process moving forward. The key to CECL success is beginning the journey now to ensure smooth travels on the road ahead.
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