On June 16, 2016, the Financial Accounting Standards Board (FASB) released the long-awaited standard updating the guidance on recognition and measurement of credit losses for financial assets—Accounting Standards Update (ASU) 2016-13, Financial Instruments–Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. The new standard supersedes today’s guidance and applies to all entities that hold financial assets not measured at fair value through net income. FASB has replaced today’s incurred loss model with the current expected credit loss (CECL) model.
In a letter to the FASB chairman on January 13, 2016, the American Bankers Association stated that “the CECL model represents the biggest change–ever–to bank accounting.” Given CECL’s far-reaching implications on an institution’s internal controls and processes, governance, risk management, allowance methodology/modeling, data collection and information technology systems, institutions are encouraged to start planning for the new standard’s implementation now.
What Is Regulatory Guidance on Implementation?
Through their joint statement issued June 17, 2016, and FAQs issued December 19, 2016, the prudential regulators have issued guidance on planning and preparing for the transition and implementation of the new standard. Institutions are encouraged to:
- Become familiar with the new standard and educate their board of directors and appropriate institution staff on CECL and how it differs from the incurred loss methodology
- Determine the new standard’s applicable effective date based on the public business entity (PBE) criteria in the U.S. generally accepted accounting principles
- Determine the steps and timing needed to implement the new standard
- Identify functional areas within the institution that should participate in the new standard implementation
- Discuss the new standard with the board of directors, audit committee, industry peers, external auditors and supervisory agencies to determine the best and most appropriate manner for implementation regarding the institution’s size and the nature, scope and risk of its lending and debt securities investment activities
- Review existing allowance and credit risk management practices to identify processes that can be leveraged when applying the new standard
- Determine the allowance estimation method or methods to be used
- Identify currently available data that should be maintained and consider if any additional data need to be collected or maintained to implement CECL
- Identify necessary system changes to implement the new standard
- Evaluate and plan for the potential effect of the new standard on regulatory capital
In addition to addressing the previously mentioned regulatory expectations, institutions should be proactive in implementing the new standard. The following information isn’t all-inclusive and additional considerations may arise during implementation.
Cross-Functional Implementation Committee
Management should consider the functional areas affected throughout implementation. One way to determine if you’ve considered all appropriate functional areas is to perform in-depth walkthroughs of the current allowance for loan loss process to document all departments and personnel involved. Create a formal implementation committee that senior management or the board of directors can oversee. Implementation committee members could include these departments:
- Information Technology
The implementation committee should develop a project plan with well-defined objectives and timelines. The committee should be tasked with updating senior management, the board of directors and audit committee on the implementation plan’s progress.
Creating Committee Objectives
Once the committee has been formed, it should set the committee’s objectives, including:
- Determine if the entity is a PBE (if not already determined)
- Determine the implementation date
- Establish a timeline
- Evaluate potential models
- Select a model(s)
- Perform data collection, validation and retention for the selected model(s)
- Refine model(s) and monitor
- Monitor additional regulatory guidance and industry practices
- Communicate progress with the audit committee, senior management and board of directors
- Update policies, procedures and internal controls
After the objectives are set, a detailed plan should be developed that assigns roles to committee members. The committee should meet on a regular basis—at least quarterly, if not monthly—to ensure tasks are on schedule and discuss any delays or hurdles.
Establish a Timeline
Once the institution has determined if it’s a PBE and set its implementation date, a timeline should be created. When setting the timeline, a best practice is to work backward from your implementation date to allow at least a year to monitor the results of the final model(s). This will enable management to verify the model is reliable prior to going live. An example timeline for a non-SEC PBE:
Evaluate Potential Models & Model Selection
The standard doesn’t mandate a specific methodology or approach. Instead, institutions can leverage existing credit risk management systems and processes to determine the model that best reflects the institution’s complexity and credit risk profile. It’s recommended institutions consider the pros and cons of various possible models before making a selection on the final model(s). Start by considering models similar to what’s currently being used, e.g., loss rate models, to determine if current practices can be leveraged. In addition, the institution should consider plans for acquisitions and growth as it may change the institution’s complexity or data availability.
Read “Potential Data Needs & Considerations with CECL” for more information on data collection's potential effects.
Refine Model(s) & Monitor
Once the selected model(s) has been developed and finalized, management should monitor the results and assess their reasonableness and directional consistency. This will allow the institution to pinpoint what’s working properly within the model and process as well as time to tweak the model and process prior to the implementation date.
Effect on Regulatory Capital
In their joint statement on CECL, the regulatory agencies stated institutions should evaluate the potential effect on regulatory capital. Although there’s an expectation CECL will increase the allowance—affecting capital adequacy—the actual effect on individual institutions will depend on several factors, including existing allowance levels, composition and credit quality of its portfolio and current and forecasted economic conditions. Regardless of the new standard’s ultimate effect on your institution, management should consider running stress tests on capital in their current capital planning process for worst-case scenarios with CECL to determine the risk to capital adequacy.
Communication Is Key
Effective and timely communication will be vital during this transition period. Communication isn’t only important among implementation committee members, but also with the board of directors, audit committee and other senior management. With every group playing a critical role, it’s important to have everyone on the same page regarding the transition status and what additional resources need to be allocated to meet the institution’s implementation date.
Contact your BKD advisor if you have questions.