June 20, 2017

CECL Financial Modeling Concerns

EXCERPT:  Following the economic crisis a decade ago, the Financial Accounting Standards Board (FASB) devised a strategy that would allow investors, auditors and regulators to anticipate future bank losses. It came up with the Current Expected Credit Loss (CECL) model, which requires banks' reserve for life of loan losses at origination. Banks are concerned about this, as it will put undue stress on those that have yet to resolve data challenges.

Due to the CECL implementation, accounting for financial institutions is experiencing major changes that have many banks concerned.

Last June, the Financial Accounting Standards Board (FASB) announced the Current Expected Credit Loss (CECL) standard to find ways that financial reporting could be improved, a process which actually started back in 2008 following the economic crisis. 

This model is creating a good deal of apprehension among financial institutions, most of which centers around the lifetime expected loss reserve for financial instruments. 

CECL will require financial institutions to make changes in their approach with reserve processes by using a lifetime expected loss estimate rather than an incurred loss approach. This new requirement will have a major effect on financial institutions' reporting and disclosures, which will become much more complex. In order to remain in compliance in the eyes of regulators, auditors, and investors, banks and financial institutions will require a comprehensive understanding of their reserves.

The FASB now expects financial institutions to start immediately recording the entire amount of credit losses that they anticipate in their loan portfolios.

These new rules have been put in place in an effort to rectify an issue that regulators, investors, and accountants witnessed following the 2008 financial crisis. 

Banks, lenders, insurers, and other financial institutions with some risk on their loan portfolios were only able to report losses when they occurred or if they were highly anticipated to happen. This left them incapable of reporting future anticipated losses and setting reserves aside under the previous accounting rules. However, it was evident that financial institutions were likely going to be experiencing years of losses, and as such, investors and regulators wanted to be made aware of what these losses would be. 

Reporting and accounting functions are expected to be a lot more complex due to the larger role of allowances in banks' financial statements.

That's where the CECL comes in - to set forth a set of accounting rules for credit risk which would allow interested parties to foresee estimates of future risk. Unfortunately, there's potential for inadvertent ramifications for banks depending on how these rules are understood and implemented.

Challenges Banks Face With CECL

Banks will certainly be met with challenges as a result of the final version of CECL. For starters, reporting and analytics will likely be substantially more complicated as a result of the allowances having a much larger role in banks' financial statements. As such, financial institutions will be faced with the need to more closely track their data to identify changes between reporting periods.

In addition to having to incorporate historical loss rates, banks will also be required to include forward-looking assumptions into their calculations. They'll be required to confirm these assumptions and how they will affect the reserve as it changes over time, which will be a major adjustment from the traditional adage that the allowance is a reflection of already incurred losses. 

Financial institutions are highly concerned that CECL's requirement for lenders to log an immediate loss when issuing any type of loan that's not offset by any interest income will create a major drag on capital. 

Gearing Up For Changes

Financial institutions have already undergone rapid change since the financial debacle a decade ago, from more stringent regulatory requirements to more complex accounting standards to more detailed and frequent disclosures. As a result, many banks have been dealing with manual processes that are much more tedious and harder to control. 

New CECL Standards Warrant Guidance From Experienced Loan Sale Advisors 

Experts estimate that loan-loss reserve balances are expected to go up as much as 30 to 50 percent as a result of CECL. The integral purpose of CECL is that financial institutions will need to replace an incurred loss tactic with a lifetime anticipated loss estimate, which is expected to entice them to buy more short-term assets as opposed to longer-term assets. In order to avoid the write-down, issuers will sell or securitize loans immediately.

What financial institutions should do is tap into all available tools that will help optimize their loan portfolios while remaining in compliance with regulations.  

Garnet Capital is in the business of helping all types of financial institutions to both acquire and sell loan assets in order to strengthen the profitability of their loan portfolios while minimizing risk. 

Find out more about what Garnet Capital can do for your financial institution and register for our online portfolio auction system today.