On March 11, 2020, the World Health Organization declared the Covid-19 outbreak a global pandemic. Since then, community banks throughout the Midwest and nationwide have adapted to working remotely, scrambled to fund billions of dollars of loans through the Paycheck Protection Program, and modified terms on thousands of loans to help our struggling community members and address shrinking margins brought on by incredibly low interest rates. Midwest community banks tackled these challenges while we were helping our kids learn remotely, eating room temperature carryout, figuring out the mute button on Zoom calls and just hoping our new Covid puppies wouldn’t bark during weekly check-in calls.
I know what you may be thinking: “We are on the other side of this pandemic, my employees and customers are receiving vaccinations and finally coming back to the office and branch, and this guy has the gall to bring up CECL!?” In short, yes. But hear me out. Amid all of the Covid-19 accounting confusion, the adoption date for ASC 2016-13, Financial Instruments – Credit Losses (Topic 326), did not change. Your bank must adopt Topic 326, aka the current expected credit losses methodology, on Jan. 1, 2023, as reflected in your March 31, 2023, call report filing.
The pandemic has most likely sidetracked adoption and implementation plans and you may feel like you are back to square one. Given mass adoption is 14 months away, CECL fervor will pick up in the coming months. Before the CECL conversation goes mainstream, allow me to dispel a few CECL myths, offer insight gleaned from the more than 150 publicly traded banks that have already adopted the standard, and offer a sensible solution to consider for your CECL problem.
Common CECL myths
Initially, I read the CECL standard issued by FASB because I am a glutton for punishment. Recently, I re-read the standard because confusion abounds within the industry as to what is required versus what has been projected from software providers, accounting nerds, and the largest and most complex financial institutions throughout the country. While this guidance has been well intentioned and helpful to many, I believe it may have perpetuated myths in the marketplace surrounding the CECL standard.
Before addressing these common myths, let me provide a simple CECL refresher. Simply put, CECL requires loans to be presented at the net amount of what is expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of loans in order to present this net carrying value of what is expected to be collected. The main difference between CECL and today’s incurred loss model is the time period for estimating losses. Under the incurred loss model, one reserves for losses that are probable at the reporting date. CECL requires that one reserves for credit losses that are expected over the remaining life. Below are common myths related to CECL followed by reality-based responses.
MYTH: Quantitative information is required to support qualitative assumptions, such as current condition adjustments and forecast estimates.
REALITY: Topic 326 does not require quantitative assessments to support current condition adjustments or forecast adjustments, which are qualitative assumptions, much like qualitative loss factors today. Topic 326 requires estimating expected credit losses over the contractual term of loans adjusted for prepayments. Historical credit loss experience of loans with similar risk characteristics, i.e., loan pools, generally provides a basis for an entity’s assessment of expected credit losses. An entity shall consider adjustments to historical loss information to reflect changes in current conditions and reasonable and supportable forecasts. These adjustments may be qualitative in nature.
In plain English, the CECL gods are saying that one starts with historical loss information and adjusts for factors today and factors in the future. These factors are called the “current condition adjustment” and “forecasted loss adjustments.” Nowhere within Topic 326 does it state current condition and forecast adjustments need to be quantitatively derived from complex statistical models, such as regression, that predict future losses based on historical relationships of loss to changes in economic indicators such as unemployment, commodity prices, interest rate movement, etc. There is no prescriptive method outlined in Topic 326 related to current condition forecast adjustments. The development of these critical assumptions can be performed in a variety of ways, including top-level qualitative adjustments. With that being said, documentation of how qualitative assumptions were chosen, derived and consistently applied is critical to a successful adoption.
MYTH: The use of peer losses is required when developing historical loss analyses.
REALITY: Topic 326 states historical loss information can be sourced from internal, external or a combination of both when developing historical loss analyses. Nowhere in the topic does it state that external information, i.e., peer loss data, is required.
MYTH: An institution needs many years of historical loss information to adequately estimate future credit losses.
REALITY: Topic 326 does not state historical loss information is required for a full economic cycle, or many years. Instead, it only states that management may use a historical period that represents management’s expectations for future credit losses. If management believes losses from 2010 are not representative of losses in 2024, that information should not be used. However, there may be benefit in using a long-term historical loss average to supplement periods outside of a bank’s forecast period, which is typically one to two years. Having more loss information at your disposal helps support reserves without heavy reliance on qualitative loss factors.
MYTH: Financial institutions should purchase software that will assist in estimating credit losses in order to comply with the standard.
REALITY: The CECL standard does not require the use of software when developing the estimate of credit losses. It does not require specific approaches when developing the estimate of expected credit losses. Instead, it explicitly states adopters should use judgment to develop estimation techniques that are applied consistently over time and should faithfully estimate the collectability of loans. Admittedly, a little direction would be nice. While many early adopters found software beneficial specifically through process automation, the standard does not require its use.
MYTH: If my financial institution purchases software to assist in the CECL calculation, management can simply rely on its outputs.
REALITY: This myth has been a challenge to overcome. While software applications can be powerful, helpful tools, management must be able to document their understanding of conceptual design and assess the reasonableness and appropriateness of assumptions and the resulting allowance estimate. A software application in and of itself cannot tackle the CECL standard given its subjectivity.
MYTH: Financial institutions with more than $1 billion in total assets are no longer “smaller and less complex.”
REALITY: The term “smaller and less complex” has been popularized through interagency guidance on CECL, risk management and compliance. The agencies have yet to define what exactly is “smaller and less complex.” Until then, this classification remains subjective and based on more than an arbitrary asset size.
CECL insights; lessons learned
Approximately 150 financial institutions adopted CECL as of Jan. 1, 2020. These early adopters are concentrated in publicly traded institutions. Of the approximately 1,500 banks in the Midwest, only a handful were early adopters. Further, of the 1,500 banks in the region, 1,327 are under $1 billion in total assets and 1,173 are under $500 million in total assets as of Dec. 31, 2020. Expectations for the vast majority of banks in the Midwest will not be the same as those banks that adopted CECL as of Jan. 1, 2020. However, there are some universal lessons learned that should be contemplated by banks of any asset size.
Looking at the 10 CECL adopters less than $50 billion in assets as of March 31, 2020, with the most significant increases in reserves as a percentage of loans, all but one had an acquisition in 2018 or 2019. This increase in reserves upon adoption was expected as accounting for credit losses on acquired loans has materially changed as part of the CECL standard. Historically, purchased loans fell under separate guidance that didn’t allow for the recognition of an allowance at acquisition. Under the CECL standard, an allowance for credit losses is to be recorded on purchased loans, regardless of the purchase accounting discount on those loans.
Another effect of adopting the CECL standard was an overall increase in allowance for unfunded commitments. With the adoption of CECL, increases on unfunded commitments were expected. Of the early adopters with less than $50 billion in total assets, 21 percent experienced a more significant effect from unfunded commitments at adoption compared to loans outstanding. Further, nearly half of these adopters indicated 20 percent or more of the total CECL allowance increase derived from reserves on unfunded commitments. This impact is due to the fact that many institutions did not previously record an allowance on unfunded commitments. CECL defines an approach and requires adopters to record an allowance for unfunded commitments that are not unconditionally cancelable.
CECL requires “reasonable and supportable forecasts” when determining expected credit losses. “Reasonable and supportable forecasts” make the standard forward looking, can be viewed as the biggest change within the standard, and are the most significant assumptions when estimating future credit losses. We reviewed public filings for 116 CECL adopters with less than $50 billion in total assets and noted 68 used either one (39 adopters) or two years (29 adopters). Twenty-three adopters did not disclose the forecast period. CECL does not require an entity to create an economic forecast over the contractual life of loans. Rather, for periods beyond which the entity is able to make reasonable and supportable forecasts, reversion to historical loss information is required.
A practical solution
Planning, preparing and researching for your upcoming CECL adoption is the last thing you want to do right now. Most of you represent true community banking and feel like this standard was not intended for the size and complexity of your institution. And while the market is ripe with powerful software applications, you question if the cost and complexity of those solutions is commensurate with the risk at your institution.
I have always been taught to never address a problem without offering a related solution. Our team has developed “CECLsimplified.” Our solution is geared toward community banks and delivers the rare one-two consulting punch: An understandable CECL tool coupled with a BKD Trusted Advisor who assists with the development and documentation of your unique CECL calculation. With our help, you can be “CECLing” independently (and accurately) after initial adoption.
Michael Flaxbeard is a senior manager at Springfield, Mo.-based BKD.