It’s been about six years since the Financial Accounting Standards Board (FASB) unveiled its current expected credit loss (CECL) model for estimating credit losses.
After several deferrals, the new model is finally set to take effect in 2023 for nonpublic entities, including most community banks. (Technically, these nonpublic banks must adopt the new model for fiscal years beginning after December 15, 2022, or 2023 for calendar-year banks.)
By now, all banks are familiar with the CECL model, and most have taken concrete steps toward adopting it. If your bank is behind schedule in its transition efforts, kick those efforts into high gear. Time is running out, and the FASB has indicated that no further deferrals are expected. (See “FASB: No more CECL delays” below.)
New model in a nutshell
Under pre-CECL rules, banks generally measure credit impairment based on incurred losses. Under the CECL model, they’ll apply a forward-looking approach, recognizing an immediate allowance for all expected credit losses over an asset’s life. The FASB adopted the new guidance based on its view that the incurred-loss model, which delays recognition of credit losses until they become probable, provides information that’s “too little, too late.” The CECL model addresses this weakness by requiring banks to record credit losses that are expected but do not yet meet the “probable” threshold.
The CECL model’s requirements are complex. But many banks are expected to substantially increase loan loss reserves, which may have a negative impact on earnings and regulatory capital. The consequences for your bank depend on its circumstances. However, with some preparation, you can anticipate the impact on financial performance and take steps to prepare for it.
Selecting a methodology
Most banks have already identified the methodologies they’ll use to estimate credit losses. If you haven’t, time is of the essence: You must have the systems and processes in place to collect and analyze the data your methodology requires. Plus, it’s helpful to do some trial runs to test the methodology before the implementation date.
The CECL model provides banks with the flexibility to use their judgment in selecting methodologies for estimating credit losses that are both appropriate and practical. And the federal banking agencies have said that they don’t expect smaller, less complex institutions to implement complex modeling techniques. Rather, the CECL model will be scalable to institutions of all sizes, and regulators anticipate that many banks will be able to satisfy its requirements by building on existing systems and methods.
Many community banks have opted for one of these two popular methods:
The weighted average remaining maturity (WARM) method. Briefly, under the WARM method, a bank estimates the allowance for credit losses by applying an average annual loss rate to the projected paydowns of loans. One reason for this method’s popularity is that it’s viewed as the closest thing to traditional methods of accounting for loan and lease losses (ALLL), so the required data tends to be more readily available.
The Federal Reserve’s Scaled CECL Allowance for Losses Estimator (SCALE) method. This is a spreadsheet-based tool that, according to the Fed, “draws on publicly available regulatory and industry data to aid community banks with assets of less than $1 billion in calculating their CECL allowances.”
The right method depends on several factors, including your bank’s complexity, available data, and resources. Depending on your circumstances, you may want to consider more sophisticated methodologies, such as discounted cash flow techniques.
Parallel testing is critical
One reason your bank needs to select a CECL methodology as early as possible is to give management time to do some parallel runs to validate the methodology before you “go live.” This means running your CECL model (or even multiple CECL models) at the same time as your existing ALLL model and comparing the results. Parallel runs provide several important benefits, including helping you spot errors and make appropriate adjustments to your new model’s variables. They also offer you a sneak preview of the CECL model’s impact on your bank.
If you have the luxury of running multiple models parallel to your existing ALLL model, you can evaluate a range of potential CECL loss estimates and evaluate which provides the most appropriate reserve. Or you might even consider selecting different models for different portfolio segments, if appropriate.
Stay in control
As the transition to the CECL standard approaches, it’s also important to evaluate — and, if necessary, update — your policies, procedures, systems, and internal controls to ensure that your credit losses will be properly calculated and documented. Ideally, they’ll be in place early enough to be operated as part of the parallel runs described above.
Sidebar: FASB: No more CECL delays
In light of previous deferrals of the CECL standard’s effective date for nonpublic entities, as well as the disruption and economic uncertainty caused by the COVID-19 pandemic, many community banks hoped that another reprieve was in the works. But in February 2022, the FASB voted not to defer the effective date any further.
Despite the implementation challenges faced by smaller banks, the FASB decided that simplifications had been made to the CECL model that eased the impact on smaller institutions. It also emphasized the importance of applying a unified standard across all financial institutions.
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