Will Newcomer

As deadlines loom for new accounting and regulatory frameworks, firms must ensure they have the right management structures and IT systems in place. Here Will Newcomer (right)  vice president of Product and strategy, Americas, and Bart Everaert (below) market manager, risk & finance, Americas,  from Wolters Kluwer examine what can be done to prepare for the new standard

In June 2016, the Financial Accounting Standards Board (FASB) made official the much-anticipated Current Expected Credit Loss (CECL) standard. While the effective date seems far off –public business entities that are SEC filers must be compliant with CECL procedures starting in 2020, for all other institutions the standard will be enforced a year later –it will be a game changer. Financial institutions will have to determine their allowance for credit losses in a different way, affecting not only accountants, but also loan officers, internal auditors, chief credit officers and, of course, IT personnel.

The issuance of CECL concludes a journey that began in the wake of the global economic crisis. During that time, the delayed recognition of credit losses associated with loans was seen as a weakness in the application of existing accounting standards, a factor that was determined to have contributed significantly to the financial crisis. As a result, the FASB began exploring alternatives that led to the use of a more forward-looking assessment. (Similarly, the International Accounting Standards Board’s overhaul of accounting protocols for IFRS 9 takes effect even sooner in countries where US GAAP principles are not the norm.)

The new accounting procedures will force bankers to keep their eyes on the road ahead, although there is a good chance of being pulled in several directions. And notably The American Bankers Association has developed a CECL-dedicated website to empower its members to come together, share, and learn the best ways to implement CECL.

Several routes into the future

With its emphasis on predicting credit losses, IFRS 9 is viewed as an improvement on the traditional incurred-loss model, i.e. IAS39, which only recognized losses after a default or other triggering event. CECL is intended to make the same upgrade to the U.S. method of accounting for credit risk but will force organizations to account for the expected lifetime losses of every transaction, no matter the significance of its credit deterioration.

Bart Everaert

Other ways in which the standards diverge relate to the fact that the CECL standards allow for ECL computations to be solely based on historical losses if these represent a good reflection of the current state. Also, the FASB standard allows deals to have a zero expected credit loss in the event reasonable and supportable forecasts result in an expectation of full payment.

 

Preparing for and implementing CECL will compel banks to think about credit risk in new ways and to develop new models to account for it, with matters being especially thorny and complex for institutions that operate across borders. Such a formidable undertaking will also require effective communication among all of the business functions—risk, finance, compliance, reporting and technology.

Global financial institutions almost certainly will have to comply with several standards and reconcile the results with one another. They will have to make sure that each department is consistent in its use of the numbers produced from a given set of calculations, analyses, forecasts and reports so that they can be interpreted effectively and used by senior management to draw proper conclusions about the operating environment and make appropriate decisions.

That effort will be all the more difficult to accomplish, given that new regulatory and accounting frameworks call for bankers to adhere to principles that are open to interpretation, and therefore to misinterpretation, rather than fixed rules. Flexibility, as it turns out, can be a double-edged sword. Success in integrating these standards into one’s organizations will depend on having proper risk management, reporting and general operating practices, and the data systems to execute them.

The long road ahead

Under CECL, credit positions are quite literally born to lose. As soon as one goes on the balance sheet, it is accompanied by an expected credit loss (ECL) that must be continually monitored and recalculated when a material change in payment prospects occurs. Allowances for stable and riskier assets alike, from the moment they appear on the balance sheet, must reflect lifetime losses estimated to occur on defaults anticipated for as long as the assets are held on the books.

Furthermore, firms should devise their own assumptions and analytical methodologies in measuring expected credit losses, per FASB’s June 2016 guidance, “based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the
reported amount.”

Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted. Organizations will continue to use their best judgment to determine which loss estimation method is appropriate for their circumstances.

Moving forward with CECL

The aim of accounting standard setters is to devise a mechanism for banks to estimate the risk of loss. For regulators, the goal is to avert, or at least mitigate through diligent preparation, damage to the financial system and the banks that make it function. For regulators, accounting standards are a means to that end. CECL is the consummation of finance, risk and regulatory reporting by embedding aspects of all three within one standard.

Because CECL touches on the above three principal functions at an organization—finance, risk and regulatory reporting—it is essential that the enterprise providing the systems can offer the technology, as well as the brainpower of its human experts, to support all three. Expertise in one or even two is not good enough.

Once the right systems are in place, the dovetailing of management and regulatory objectives permits firms to leverage the systems to accommodate the need for greater cooperation and communication among functions, particularly risk and finance, and at all levels of management in all places. That means a single system with the flexibility to behave like many smaller ones, allowing data to be shared and manipulated for analysis, forecasting, budgeting and planning in ways that conform to the needs of each part of an organization.

Such a capability also serves the ultimate goal of creating a safer, more efficient institution, which is the whole point of the new regulatory and accounting frameworks, of course. This also means that companies might have already started the journey. One benefit of having so many intersecting challenges and objectives is that firms that have begun to configure their systems to conform to finance, risk and regulatory reporting practices have also begun, whether they realize it or not, to prepare for CECL.

The future is not now, but it is close

The introduction of new standards and the discrepancies between them present fresh dilemmas for senior bankers, especially because the standards call on them to make better guesses about something inherently unknowable and unquantifiable—the future. There are still many unknowns concerning the impact that CECL will have, especially because its final form may not yet be written.

What is certain is that, unless they are being unduly modest, firms are not ready for implementation and what lies beyond. Bankers must prepare for a future in which the main focus of analysis will be an even more distant future. The only catch is that they must complete their preparations before these deadlines arrive—which will be here sooner than many anticipate.

Taking Bankers’ Pulse on CECL

How are banks viewing the new CECL standard?  In a recent educational webinar for banks hosted by Wolters Kluwer, 44 percent of 135 respondents cited “Data Requirements” as the single biggest challenge they anticipate facing when implementing the new standard. Twenty-six percent viewed “Data Modeling” as the next biggest challenge, followed by “Complex, Ongoing Analysis as a Concern” (17%), and “Reporting and Governance” (12%).

Another polling question asked how much banks expected their loan loss provisions to increase, once CECL went into effect.  Fifty-five percent of respondents anticipated their loan loss provisions to increase “between zero to 20 %,” while another 25 percent cited “between 20 and 40 percent” in loan loss provision increases.

Finally, when asked whether banks should receive a reduction in credit risk capital requirements, given the larger loan loss provisions they will hold under CECL, more than half (54 percent) voted “yes,” whereas 20 percent voted “no” and the remaining 26 percent held “no opinion” yet on this aspect of the standard.

Clearly, banks already are recognizing the potentially seismic impacts the CECL standard will have in their day-to-day operations.

 

by Bill Boyle
IBS Intelligence Senior Editor
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