Proposed Interagency Policy Statement Addresses Allowances for Credit Losses
On October 17, 2019, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the FDIC and the National Credit Union Administration (agencies) published a proposed interagency policy statement (policy statement) on allowances for credit losses (ACL) in response to FASB Accounting Standards Update 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, and subsequent amendments issued since June 2016. The policy statement describes the following:
- Measurement of ACLs for Loans, Leases, Held-to-Maturity (HTM) Debt Securities & Off-Balance-Sheet Credit Exposures under the CECL methodology
- Measurement of the ACL for available-for-sale (AFS) debt securities in accordance with FASB Accounting Standards Codification (ASC) Topic 326
The policy statement also includes and updates the following concepts and practices detailed in the existing allowance for loan and lease losses (ALLL) policy statements that remain relevant under Topic 326:
- Documentation standards
- Analyzing and validating the overall measurement of ACLs
- Responsibilities of the board of directors
- Responsibilities of management
- Examiner reviews of ACLs
The policy statement would be effective at the time of each institution’s adoption of Topic 326 and will rescind the following policy statements previously issued by the agencies (ALLL policy statements):
- December 2006 Interagency Policy Statement on the ALLL
- May 2002 Interpretive Ruling and Policy Statement 02-3, ALLL Methodologies and Documentation for Federally Insured Credit Unions
- July 2001 Policy Statement on ALLL Methodologies and Documentation for Banks and Savings Institutions
Included below is a short summary of the items covered in the policy statement.
Measurement of ACLs for Loans, Leases, HTM Debt Securities & Off-Balance-Sheet Credit Exposures
Topic 326 does not require the use of a specific loss estimation method for purposes of determining ACLs. Various methods may be used to estimate the expected collectibility of financial assets, with those methods generally applied consistently over time. The same loss estimation method does not need to be applied to all financial assets. Management is not precluded from selecting a different method when it determines the method will result in a better estimate of ACLs. The selected method(s) should be appropriate for the financial assets being evaluated and consistent with the institution’s size and complexity.
The agencies understand estimating appropriate ACLs involves a high degree of management judgment and is inherently imprecise. As a result, this is the largest area covered within the policy statement and provides overall guidance addressing the following items under Topic 326:
- Collective evaluation of expected losses, including examples of risk characteristics relevant to this evaluation
- Contractual term of a financial asset
- Historical loss information
- Reasonable and supportable forecasts
- Qualitative factor adjustments
- Collateral-dependent financial assets
- Troubled debt restructurings
- Purchased credit-deteriorated assets
- Financial assets with collateral maintenance agreements
- Accrued interest receivable
- Financial assets with zero credit loss expectations
- Estimated credit losses for off-balance-sheet credit exposures
Measurement of the ACL for AFS Debt Securities
Per FASB ASC Subtopic 326-30, credit losses for AFS debt securities are evaluated as of each reporting date when the fair value is less than amortized cost. If management determines any portion of the unrealized loss position is related to credit risk, then measurement of credit losses is required to be calculated individually—rather than collectively—using a discounted cash flow method, through which management compares the present value of expected cash flows with the amortized cost basis of the security. An ACL is established—with a charge to the provisions for credit losses (PCL)—to reflect the credit loss component of the decline in fair value below amortized cost. The ACL for an AFS debt security is limited by the amount that the fair value is less than the amortized cost, which is referred to as the fair value floor.
Other items to consider in the measurement and accounting of the ACL for AFS debt securities addressed in the policy statement include:
- If the security’s fair value increases over time
- If management intends to sell an AFS debt security or will more likely than not be required to sell the security before recovery of the amortized cost basis
- A change during the reporting period in the noncredit component of any decline in fair value below amortized cost
- Including accrued interest receivable or evaluating the accrued interest receivable separately
ACLs and PCLs should be well documented with clear explanations of the supporting analyses and rationale. Sound policies, procedures and control systems should be appropriately tailored to an institution’s size and complexity, organizational structure, business environment and strategy, risk appetite, financial asset characteristics, loan administration procedures, investment strategy and management information systems.
The policies and procedures should describe management’s processes for evaluating the credit quality and collectibility of financial asset portfolios—including reasonable and supportable forecasts about changes in the credit quality of the portfolios—through a disciplined and consistently applied process that provides an appropriate estimate of the ACLs. Management should review and, as needed, revise the institution’s ACL policies and procedures at least annually, or more frequently if necessary.
An institution’s policies and procedures for the systems, processes and controls necessary to maintain appropriate ACLs should address but not be limited to:
- Processes that support the determination of all items listed in the Measurement of ACLs for Loans, Leases, HTM Debt Securities & Off-Balance-Sheet Credit Exposures section above and overall appropriateness of the items
- The roles, responsibilities and segregation of duties of the institution’s senior management and other personnel who provide input into ACL processes, determine ACLs or review ACLs
- Data capture and reporting systems, whether obtained internally or externally
- Management’s judgments, accounting policy elections and applications of practical expedients
- Procedures for validating and independently reviewing the loss estimation process
- The system of internal controls used in the ACL estimation process
Analyzing & Validating the Overall Measurement of ACLs
Various techniques are available to assist management in analyzing and evaluating ACLs as a supplemental check on the reasonableness of management’s assumptions and analyses. Techniques applied in these instances do not have to be complex to be effective but, if used, should be commensurate with the institution’s size and complexity. Below are examples the agencies provided:
- Comparing estimates of expected credit losses to actual write-offs in aggregate, and by portfolio
- Ratio analysis, i.e., relationship of ACLs to other factors such as adversely classified or graded loans, past-due and nonaccrual loans, total loans and historic delinquency and default trends for securities
- Comparing the institution’s ACLs to those of peer institutions
After analyzing ACLs, management should periodically validate the loss estimation process—and any changes to the process—to confirm the process remains appropriate for the institution’s size, complexity and risk profile. The validation process should include procedures for review by a party with appropriate knowledge, technical expertise and experience that is independent of the institution’s credit approval and ACL estimation processes.
Responsibilities of the Board of Directors
As noted above, practices detailed in the existing ALLL policy statements remain relevant under Topic 326. In general, the board of directors—or a committee thereof—is responsible for overseeing management’s significant judgments and estimates used in determining appropriate ACLs. Evidence of the board of directors’ oversight activities is subject to review by examiners.
Responsibilities of Management
Again, practices detailed in the existing ALLL policy statements remain relevant under Topic 326. In general, management is responsible for maintaining ACLs at appropriate levels and for documenting its analyses in accordance with concepts and requirements set forth in generally accepted accounting principles (GAAP), regulatory reporting requirements and the policy statement. In addition, if an institution uses loss estimation models in determining expected credit losses, management should evaluate the models before they are employed and modify the model logic and assumptions, as needed, to help ensure the resulting loss estimates are consistent with GAAP and regulatory reporting requirements. Management should document and support any adjustments made to the models, the outputs of the models and compensating controls applied, consistent with the Documentation Standards section above. Management’s evaluations also are subject to review by examiners.
Examiner Review of ACLs
Examiners are expected to assess the appropriateness of management’s loss estimation processes and the appropriateness of the institution’s ACL balances as part of their supervisory activities. The review of ACLs, including the depth of the examiner’s assessment, should be commensurate with the institution’s size, complexity and risk profile. More specifically, examiners will assess:
- The credit quality and credit risk of an institution’s financial asset portfolios
- The adequacy of the institution’s credit loss estimation processes, including a review of the items listed in the Measurement of ACLs for Loans, Leases, HTM Debt Securities & Off-Balance-Sheet Credit Exposures section above and models used in the process
- The adequacy of supporting documentation
- The appropriateness of the reported ACLs and PCLs in the institution’s regulatory reports and financial statements, if applicable
- The effectiveness of the controls used to support the measurement of the ACLs
- The effectiveness of board oversight as well as management’s effectiveness in identifying, measuring, monitoring and controlling credit risk
- The effectiveness of the institution’s third-party risk management framework associated with the estimation of ACLs
As a result of the flexibility and substantial degree of management judgment provided by Topic 326, examiners generally should accept an institution’s ACL estimates and not seek adjustments to the ACLs when management has provided adequate support for the loss estimation process employed and the ACL balances and assumptions used in the ACL estimates are in accordance with GAAP and regulatory reporting requirements. It is inappropriate for examiners to seek adjustments to ACLs for the sole purpose of achieving ACL levels that correspond to a peer group median, target ratio or benchmark amount when management has used an appropriate expected credit loss framework to estimate expected credit losses. View the policy statement on the Federal Register's website.
If you would like assistance complying with or understanding the guidance provided in the policy statement, reach out to your BKD Trusted Advisor™ or use the Contact Us form below.