CECL from the Inside

Q: We know that the Financial Stability Board, the banking regulators, as well as some banks, requested that the FASB amend its loan impairment accounting to be more forward-looking. The question is, why CECL?

A: Banks do not underwrite to perfection. When a bank originates loans, it has an expectation of credit losses. While a thorough underwriting process occurs to manage credit losses, historical experience shows that not every borrower will repay. Therefore, the board believes that immediate recording of an expected credit loss at loan origination is appropriate.

Throughout the project, the board considered many alternative methodologies. However, each methodology would have changed current practice significantly, and each raised new complexities that were a source of concern for the banking industry.

A common concern about those methodologies was the delayed recognition of the expected losses. An accounting standard that delays recognition of expected credit losses fundamentally must determine which losses not to recognize, why those losses should not be recognized and the period of time for which the unrecognized losses should be delayed. It is extremely difficult to answer these conceptual questions in anything other than an arbitrary manner. If a bank expects a credit loss of $5 on a loan portfolio, for example, why should anything less be recorded in the bank’s allowance?

Q: Two FASB members opposed recognizing all future losses on Day One. Were there other models that could have gained more support from individual board members?

A: It is important to note that the entire seven-member board—including the two that dissented—agreed with setting an allowance for loan losses at an amount equal to expected credit losses as required in the upcoming standard. What they disagreed on is where changes in the allowance should be presented.

Q: A CEO of a $100 million bank comes up to you and says “I didn’t cause the financial crisis, yet I am going to incur huge costs to implement CECL. What was wrong with what I was doing?” How do you respond?

A: The objective of CECL isn’t to prevent the next financial crisis. No accounting standard can change losses, just the timing of when losses are recognized. In the four years leading up to the financial crisis, loans on the balance sheets of FDIC-insured financial institutions increased 44 percent, while loan loss reserves fell 10 percent. This reflects the fact that the current “incurred” accounting methodology was not in step with the significant expansion of credit risk leading up to the crisis.

With the help of bankers, we developed CECL in a manner that allows them to leverage current methodologies and processes. Bankers have the flexibility to choose the method that is most appropriate in their circumstances. We heard from bankers that any methodology that required multiple stages of differing credit loss estimates would be operationally too complex. Among other things, they told us that spreading credit losses over an arbitrary time period resulted in many new challenges that could not be overcome. Furthermore, waiting to record the credit losses at the end was just too late.

There will be transition costs because inputs to current methodologies will have to change, employees and investors will have to be educated, and depending on the bank, initial costs may be incurred to obtain more incremental loss data than what was retained in the past. However, after transition, the ongoing costs of preparing the allowance under the new standard should not be significantly above the costs of complying with current GAAP.

A community bank has the benefit of historical loss information specific to its local community, including deep relationships with its borrowers, and can identify and observe how economic factors specifically impact that community. Such information—and insights into the local community—will make the measurement of expected credit losses more manageable for the community bank.

Q: We’ve noted before the challenges that CECL brings with the life-of-loan loss concept. Where do you think banks will struggle the most in applying CECL?

A: We learned from bankers that any expected credit loss methodology should include a forward-looking element. That’s because any expected credit loss methodology where assumptions were held constant would be too limiting. For example, it would be inappropriate to assume the unemployment rate was 10 percent forever when expectations were that the unemployment rate would be decreasing in the future.

Bankers now will have to quantify how that reasonable and supportable forecast impacts the allowance, something not done under current GAAP. However, bankers do quantify how the current economic environment impacts the allowance, so there is some past practice that can be leveraged when adding inputs related to forecasts.

We also listened when bankers said that one should not be required to forecast economic factors over the life of a loan—for example, a 30-year mortgage loan—when such forecasts are not supportable. The board agreed, and noted that for any periods after the reasonable and supportable period, a bank should revert to historical losses. It was the board’s view that it would be inappropriate to record zero losses in those periods when historical loss information demonstrates otherwise.

Finally, it’s important to note that the credit losses Transition Resource Group has been set up to monitor and address implementation issues that arise. It consists of those who will be responsible for implementing, auditing, and regulating the standard. Bankers representing institutions of all sizes are on the TRG.

Q: Do you think there are parts of CECL that banks will like?

A: Yes, absolutely. It is important to note that throughout the course of the project, the feedback from bank stakeholders has been very valuable and has impacted all areas of the final standard. Let me share some examples.

• We learned from bankers that current GAAP needed improvement, starting with removing the “probable threshold” that was required for recording credit losses. The board agreed.
• Bankers advised us that any expected credit loss methodology should consider the ability to use forward-looking information. The board agreed.
• Bankers also advised us to keep the accounting of interest income and credit losses separate. Trying to develop a methodology that integrates the two would be too complex. The board agreed, and the accounting for interest income and credit losses continues to be separate as it is under current GAAP.
• It was also bankers who noted practice issues with purchased credit impaired loans and troubled debt restructurings. The board made amendments to those areas that should simplify the accounting and disclosure practices that were cumbersome.
• We also learned that nonaccrual accounting, which is heavily practiced by banks, should be retained without any changes to it. Again, the board agreed.

Q: That same community banker now says, “I don’t have the money to throw around. What is the least I can do to get by?” What will you tell her?

A: Contrary to what you may have heard, CECL will not require banks to implement elaborate new systems or develop complex models. Although there will be additional work due to the forward-looking focus of CECL, and the underlying data needed for CECL calculations will change, many of the loss estimation techniques applied today will still be permissible, and historical experience will remain the foundation of the estimate.

The CECL standard now will allow credit risk management practices and activities to better flow through to the accounting for credit losses. There no longer will be a difference in language within areas of the bank.

Q: ABA held a roundtable earlier this year to discuss how and whether CECL is scalable for smaller institutions and how that might be done. We brought together bankers, banking regulators, external auditors, the Securities and Exchange Commission and the Public Company Accounting Oversight Board. The parties agreed to ensure CECL will be scalable for smaller institutions. How will FASB help make it scalable?

A: There is some concern among bankers that bank examiners and auditors will interpret the standard to require a specific methodology or require new and complex systems. However, bank regulators have committed publicly to the scalability and flexibility of the standard. They continue to reinforce this point in public communications, meetings and in educational initiatives with their examiners.

While standard-setting is independent of regulatory oversight, FASB has been proactive in engaging regulatory agencies regarding CECL. We are communicating on an ongoing basis with auditors and regulators, and have emphasized that CECL will not require complex and costly systems.

It also is worth noting that banking regulators serve as observers on our TRG. As I mentioned earlier, the TRG specifically was created to inform us of issues like this that may arise during the implementation phase.

Q: Do you have any advice to bankers about where to begin?

A: First and foremost, bankers should take the time to read the standard and related educational materials that we have developed. They should begin developing a transition plan now. Bankers should evaluate their current methodologies and processes, and determine what changes are necessary to be compliant with CECL. Once bank management has developed its expectation for how it will comply with CECL, it should then consider what incremental data will be needed. Collection of that identified data should start sooner rather than later.

And, of course, any transition plan should be evaluated with the bank’s board of directors, auditors, regulators and other important stakeholders to make sure everyone agrees at inception. Finally, I’d also encourage bankers to follow the activities of the TRG and to submit their implementation issues through our TRG web portal available through fasb.org.