Regulatory Update on CECL- Are You Ready for Change?

Regulatory Update on CECL

Are you Ready for Some More Change?

Michael Gullette

American Banker Association

Danielle Brogan

Primatics Financial

Overview:

What Change Does CECL Bring?

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Overview: Issues Approved in Deliberations

• Concept of the Current Expected Credit Loss Model (CECL) was approved

• Loans and Debt Securities are covered

• For financial assets measured at amortized cost, an entity should apply CECL

• FV-OCI assets will be determined on an individual basis

• FV-OCI asset have no impairment of the asset’s fair value is greater than its cost basis

• FV-OCI credit loss is not greater than calculation of amortized cost less Fair value

• Concept of Troubled Debt Restructuring (TDR) to remain

• Cost basis adjustment required

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Overview: Issues Approved in Deliberations

• Purchase Credit Impaired (PCI) Loan Accounting

• Loan balance grossed up

• Expected credit loss presented as ALLL and recorded on Day 1

• Interest income based on contractual terms of agreement (no longer based on expected cash flows)

• Interest rate (non-credit) mark recorded at acquisition conversion of each PCI loan

• Non-Accrual concept rejected

• Contractual Cash Flows (CCF)

• Consider all CCF over the life of the financial instrument

• Consider expected prepayments

• Should not consider expected extension, renewals and modifications unless a troubled debt restructuring is reasonably expected

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Overview: The CECL Model

• Departs from the incurred loss model which means the probable threshold is removed

• Not limited to expected losses over a specific time horizon but acknowledges that the degree of judgment increases as the forecast horizon increases.

• An adjustment to historical experience might be necessary to reflect current information

• Must reflect the time value of money either explicitly or implicitly

• The discounted cash flow model is an example of a method that explicitly reflects the time value of money by forecasting future cash flows and discounting these amounts to a present value using the effective interest rate.

• Other methods implicitly reflect the time value of money, such as loss-rate methods, roll-rate methods, probability-of-default methods, and a provision matrix method using loss factors.

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Overview: The CECL Model

• Does not specify any one method

• Methods used to estimate expected credit losses may vary on the basis of the type of financial asset and the information available to the entity that is relevant to the estimation process

• Does not require specific approaches or specific policy elections

• Latitude to develop estimation techniques that are applied consistently over time and aim to faithfully estimate expected credit losses

• Neither a worst-case nor a best-case scenario

• Should reflect both the possibility that a credit loss results and the possibility that no credit loss results

• A probability-weighted calculation that considers the likelihood of more than two outcomes is not required

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Overview: CECL Execution

• Many loss estimation methods to satisfy CECL are accepted:

• Discounted Cash Flows

• Historical Loss Rate Averages

• PD/LGDs

• Roll Rates / Migration Analysis

• Collateral Value

• Main Point: FASB will accept any estimation method as long as it is based on a life of loan analysis

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Operational Considerations: Modeling

• Lifetime losses from any point in a loan forward requires lifecycle models for any but the shortest term loans

• Incorporating macroeconomic conditions requires regular (monthly/quarterly) forecasting as done in stress testing models

• Computing discounted cash flows may require loan level models to capture the correct effective interest rate for the loan

• The most common models will no longer be sufficient except in the simplest of cases

• Moving average loss rates

• Roll rate models

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Operational Considerations: PCI Loans - Conversion

Calculation of effective yield

• Calculated based on the contractual loan terms and the non-credit discount at conversion

• Will vary from the accretable yield outstanding at the conversion date

Tracking amortized cost basis

• Basis of PCI loans will be grossed-up with the non-credit discount accounted for similar to the purchase premium/discount on performing loans

• Entities with a large acquired PCI portfolio may have a significant lift calculating loading the data into the system

• In general, amortized cost basis is not something entities currently track closely

End of Pool Accounting

• All current pooled loans begin to be accounted for individually

• Push down pool recorded investment to the individual loan level• Necessary to separate the credit and non-credit discount for each loan

• Assumes entities have tracked individual loan events while still employing pool accounting

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Operational Considerations: PCI Loans

Fold PCI loans into existing originated accounting

• Increases the number of loans subject to effective yield amortization

• Increases materiality if calculating the amortization using a simplifying assumption• Loans must be included in disclosures with originated loans

• Particularly challenging if acquired entities were not converted onto existing systems

Subsequent acquisitions will be handled differently

• Change to the definition of PCI loans

• Current guidance defines PCI loans as those with evidence of credit deterioration since origination and where it is probable the investor will not collect all the cash flows

• Proposed guidance defines PCI loans as those where there has been significant deterioration of credit since origination

• No longer any mention of collectability of cash flows• Allowance is recorded on PCI loans on the acquisition date

• Treatment would vary as compared to non-PCI loans where no allowance is recorded at acquisition

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Operational Considerations: TDR Modifications

Current guidance related to TDR identification remains unchanged

• Entities can continue to employ current practices to determine whether a modification is considered a TDR

TDR modification is not viewed as a new loan

• Considered the on going recovery of a financial asset

Pre-modification effective yield continues to be applied to the post-modification loan

Allowance on TDR loans is not required to be calculated at the individual loan level

• If a discounted cash flow model is used, the pre-modification effective yield is used to calculate the NPV

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Operational Considerations: TDR Modifications

Guidance is updated to require an adjustment to the cost basis of the loan

• Decrease cost basis when the Modified loan NPV < Amortized Cost Basis

• Increase cost basis when the Modified loan NPV > Amortized Cost Basis in certain TDRs (to be clarified upon issuance based on deliberations by the FASB)

• Off-set to the adjustment is recorded to the allowance for loan and lease losses

• Will require an update to current accounting process so the write-down associated with the concession can be tracked

Proposed guidance appears to broaden the population of loans for which collateral value can be used to determine impairment

• Provides that collateral value can be used when repayment is “expected to be primarily or substantially through the operation or sale of the collateral”

• Current guidance provides that collateral value should be used only when repayment is solely expected to be from the asset sale

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Disclosures

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Disclosures: Integration of Accounting and CreditDisclosure Description Difficulty Why Difficult

Credit Quality Information

The purpose of this disclosure is to enable the user to understand the credit quality of the portfolio and how management assesses risk.

Requires the amortized cost basis to be disaggregated by credit quality indicators used to assess risk at the portfolio segment and asset class level.

Medium This is already part of the banking institutions’ disclosures for financing receivables as of the issuance of ASU 2010-20 effective in December 2010 for public companies. CECL expands the credit quality information requirements to all financial instruments recorded at amortized cost or FV-OCI.

This disclosure may be challenging for non-banking institutions unfamiliar with this disclosure.

There is inherent risk associated with combining accounting balances and classifications with credit related loan characteristics when accounting and credit information is often housed in different source systems.

Changes in the Allowance due to Shifts in Economic Forecasts

The purpose of this disclosure is to understand the method and information used to calculate the allowance as well as how the current and projected forecasts drive the estimate.

Requires a description of the past events, current conditions, and reasonable supportable forecasts for each portfolio.

Changes in the factors leading to an increase or decrease in the loss expectations and the reason for the change should be discussed at the portfolio level.

Challenging The forecast of future economic circumstances, is a new and challenging element added to the allowance for credit losses disclosure.

The potential for expected credit loss volatility is high. Collaboration between the credit and accounting groups will be necessary in order to attribute changes in the expected credit loss for the period to changes in future economic forecasts and loan risk characteristics. Forecasts of future economic conditions are highly judgmental; documentation and transparency will be critical in order to adequately support the forecast.

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Disclosures: Integration of Accounting and CreditDisclosure Description Difficulty Why Difficult

Allowance for Expected Credit Loss Roll Forward

Provide the beginning balance, provision for credit losses, writeoffs, recoveries, and the ending balance of the allowance for expected credit losses during the period.

Easy This disclosure requirement is similar to the current requirement to disclose the activity in the allowance for credit losses in ASC 310-10, but requires that the roll forward be disaggregated at the portfolio level.

Debt Instrument Roll Forward

Provide a roll forward of instruments classified at amortized cost which includes the beginning amortized cost, originations, purchases, sales, repayments, writeoffs, amortization, and the ending amortized cost for the period at the portfolio segment level.

Medium This is a new requirement for all institutions.

Some entities may find it challenging to allocate loan activity to the portfolio segments.

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Disclosures: Integration of Accounting and CreditDisclosure Description Difficulty Why Difficult

Past Due Status

Disclose when a debt instrument is considered to be past due, and provide an aging analysis of the amortized cost for debt instruments that are past due as of the reporting date at the portfolio segment level.

Medium This is similar to the current disclosure requirement for nonaccrual and past due financing receivables in ASC 310-10.

Some entities may find it challenging to provide the amortized cost basis of the debt instrument

Non-Accrual Status

Provide the following by portfolio segment:-amortized cost of debt instruments in nonaccrual during the beginning and end of the period-Amortized cost of debt instruments that are 90 days or more past due, but are in accrual status-Amortized cost of debt instruments on nonaccrual status for which there are no related expected credit losses because the instrument is fully collateralized- interest income recognized on assets in nonaccrual .

Medium This requirement expands on the current disclosures for nonaccrual and past due financing receivables, and covers a broad range of information including the estimated allowance, interest income, collateral values, and the amortized cost basis of nonperforming loans.

A roll forward of loans on nonaccrual status is ideal when providing the nonaccrual balance at the beginning and end of the period. For example, if the nonaccrual balance decreases, attributing the decrease to loans returning to accrual status is indicative of different credit expectations than if the decrease is due to writeoffs of nonperforming loans.

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Disclosures: Integration of Accounting and CreditDisclosure Description Difficulty Why Difficult

Purchased Credit Impaired Financial Asses

Provide a reconciliation between the fair value and the face value of purchased financial assets that have experienced a significant deterioration in credit quality.

Provide the following in the period of purchase:-Purchase fair value-Discount attributable to expected credit losses-Non-credit related discount/premium-Unpaid principal balance

Easy The proposed accounting for Purchase Credit Impaired (PCI) loans is different than the current guidance, but the proposed disclosure is relatively straightforward.

The amortized cost basis of the financial asset is equal to the purchased fair value gross of the allowance for expected credit losses.

The difference between the fair value and principal balance is segregated by a credit mark and an interest mark. During a FASB meeting the board tentatively decided that an entity will be required to allocate the non-credit-related discount or premium to the individual asset level.

This requirement applies to PCI loans only, though, feedback suggests that preparers prefer to account for non-PCI loans consistently with PCI loans.

Collateralized Financial Assets

Describe the type of collateral by class of financial asset, and qualitatively describe the extent to which collateral secures an entity’s financial assets.

Qualitatively explain by class of financial asset significant changes in the extent to which collateral secures an entity’s financial assets.

Medium Current credit related loan characteristics such as updated appraisals, loan-to-value (LTV) ratios, and the house price index (HPI) will be needed to convey the extent to which the financial assets are secured by collateral.

This will require coordination between the accounting and credit groups when considering the collateral values associated with the outstanding debt balances.

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CECL: Disclosure Issues to be Discussed by FASB

• Detail regarding the changes in factors related to the estimate

• Roll Forward of the loan / securities balances

• Additional detail of the credit quality: LTVs, FICOs, Detail within pass category

• Removal of additional non-accrual disclosures

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CECL: Issuance Details

• Targeted 2014 issuance

• Effective date unknown; 2018???

• Per comment letters, most respondents indicated implementation of the standard would take two years

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Q&A