The issuance of the new current expected credit loss (CECL) standard in June 2016 represents a substantial accounting change, and many boards are trying to determine how their institutions will comply with the new standard. In Frequently Asked Questions on the New Accounting Standard on Financial Instruments—Credit Losses, the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corp. and National Credit Union Administration (collectively, the Agencies) state that they expect supervised institutions to make good-faith efforts to implement the new accounting standard in a sound and reasonable manner. Given the likely expectation that CECL will increase allowance levels and lower capital, regulatory expectations will be heightened.
Significant changes in the Allowance for Loan and Lease Losses (ALLL) are not unique. Institutions can look back just 20 years and recognize regulatory guidance that looked at percentages of classified loans as a measure of ALLL adequacy irrespective of the methodology chosen under generally accepted accounting principles (GAAP). Refinements in 2001 and 2006 furnished guidelines of acceptable ALLL methodologies to provide consistency for GAAP and regulatory purposes. Although mathematically accurate, as seen with the recent financial crisis and long recovery period, it’s becoming increasingly difficult to measure and react to changing economic conditions.
A noted benefit to the new standard is the flexibility in determining expected losses. The Agencies recognize this flexibility, but institutions should use judgment in developing estimation methods. Any method chosen should be well-documented, applied consistently over time and provide a good-faith estimate to the collectability of financial assets. Further, the Agencies have commented that smaller and less complex institutions will be able to adjust their existing allowance methods to meet the new accounting standard’s requirements without the use of costly, complex models.
So how do financial institutions focus on getting this methodology change right, and what should the board be focused on?
The board of directors plays a pivotal role in the effective governance of its institution by overseeing management and providing organizational leadership through core corporate values. This helps keep the institution operating in a safe and sound manner, and comply with applicable laws and regulations. Directors are not expected to be actively involved in day-to-day operations, but should provide clear guidance and monitor risk exposure through established policies, procedures and practices. The board, typically through an established audit committee, has broad oversight to monitor the financial reporting process and oversee the financial institution’s establishment of accounting policies and practices. In anticipation of implementing CECL, the board should consider reviewing the significant qualitative aspects of the bank’s accounting practices, including accounting estimates, financial reporting judgments and financial statement disclosures.
Existing regulatory guidance provides a roadmap of expectations regarding the ALLL methodology, and expectations will likely remain unchanged with the new CECL standard. The guidance states that for an institution’s ALLL methodology to be effective, the institution’s written policies and procedures should address:
- The roles and responsibilities of bank personnel involved in the ALLL process,
- The institution’s accounting policies affecting the ALLL,
- A narrative of the institution’s methodology, and
- Documentation of the internal controls used in the ALLL process.
Some institutions are considering the use of third-party vendors for CECL implementation, and in this case, boards should ensure their institutions have appropriate processes in place for selecting vendor models. As part of this process, institutions should require that the vendors provide developmental evidence explaining the product components, its design and proof that the product works as expected, with an understanding of the model’s limitations. Whether the model is developed in-house or by a vendor, all model components, including input, processing and reporting, should be subject to an independent validation that’s consistent with current regulatory guidance. Also, depending on the complexity of the method chosen, certain models likely will be within the scope of the Agencies’ model risk management guidelines, and institutions will need to consider ways to effectively challenge those new models.
Boards should become familiar with the new standard and work with management to understand the plan to implement it, based on the institution’s size and complexity prior to the applicable effective date. Boards should also make sure they’re regularly updated on the status of implementation efforts. It’s expected that examiners will begin to inquire about the status of institutions’ implementation efforts and as the effective date nears, examiners will want to know the new standard’s effect on the bank’s capital levels.
Implementing CECL will be a significant challenge for institutions that aren’t diligent and timely in creating and executing a plan with input from many key stakeholders—including the board. Active participation on the part of directors will be critical in its success.