[IMGCAP(1)]Responding to concerns about their allowance model and in an attempt to simplify impairment guidance for financial institutions, the Financial Accounting Standards Board has issued several exposure drafts of proposed models to take into account “expected losses” rather than the current “incurred loss” model.
On Dec. 20, 2012, FASB issued a new version of an exposure draft outlining a new “current expected credit losses” model with its Accounting Standards Update (ASU) Financial Instruments- Credit Losses (Subtopic 825-15).
Under the current U.S. GAAP-supported incurred loss model, a financial institution would not record a loss until it is probable that the asset is impaired or if there has been a triggering event for an incurred loss.
FASB’s most recent exposure draft moves to assess “expected losses” instead of incurred losses, and it shies away from the previously proposed “three-bucket” approach that the International Accounting Standards Board still supports.
The “Current Expected Credit Losses” Model
FASB’s newly issued exposure draft follows a model it calls the “current expected credit losses,” or CECL, model. Here are a few key changes suggested by the new guidance:
1) Forward-looking analysis: Current GAAP guidance requires the use of past and present events, but the CECL model would require an institution to utilize future information and supportable forecasts to estimate the allowance. This forward-looking analysis could pose problems for community banks, as they might not be resourced with the proper models.
2) Removal of “probable” threshold: Currently, a financial institution is not required to record a loss until a loss on the asset is deemed to be “probable and estimable.” CECL requires that an institution forego the worst-case or best-case scenario and instead evaluate the possibility that a loss exists or that it does not. It should not use the “mode” or the most likely scenario, as is used in the current model.
3) Loss horizon changes: The incurred loss model estimates losses for loans likely to default in the next 12 months, while the new guidance requires an institution to estimate losses over the lifetime of the loan for all loans. This would likely expand the loss horizons that an institution uses for estimating an allowance for its non-impaired loans and will likely cause the allowance for non-impaired assets to rise from current levels.
4) “Time and Money”: Under the proposed guidance, estimates must take into account the time value of money explicitly or implicitly.
5) Redefinition of a collateral-dependent asset: The proposed guidance defines a collateral-dependent asset as “a financial asset for which the repayment is expected to be provided primarily or substantially through the operation (by the lender) or sale of the collateral,” broadening its definition from “solely” to “primarily or substantially” and clarifying that operation should only be considered if it is operated by the lender as opposed to the borrower.
Effects of CECL on Allowance Levels
Allowance levels as a whole would likely rise with the implementation of FASB’s latest proposal. The final amount by which the allowance changes will be determined by an institution’s portfolio composition, portfolio vintage, current methodology, forecasts of future events, etc.
Most of the increase could be attributed to the fact that an institution would now need to utilize future forecasts to estimate losses and that it would need to utilize an estimate of “lifetime of loan” losses. This new methodology would cause an increase in reserve levels, particularly for the non-impaired portfolio (current FAS 5 [ASC 450-20]).
Additionally, the change that would require an institution to now hold a day one allowance for purchased credit impaired assets would also cause a rise in allowance levels, although it would have a net-neutral effect on earnings as the increase in reserves would also be added to the amortized cost of the loans.
An institution using the CECL model would likely recognize losses earlier at the beginning of a downturn, so its provision level would increase during this point in the economic cycle. Then during the downturn, there would most likely be a smaller provision since these losses would have already been recognized. Finally, there would be a higher provision coming out of the downturn rather than the allowance release typical under the current model.
In theory, the CECL model could provide for less volatility in the allowance. Some observers have pointed out, however, that the model could in fact cause higher volatility, particularly because of the difficulties around trying to estimate the impact of future events. There is some concern that added volatility in the allowance could be cause for requiring an additional capital buffer on top of other, proposed capital requirement increases.
There is no timeline established yet for when the new guidance would take effect. Given the difficulties of reconciling the new FASB guidance with IASB guidance, as well as concerns over other pending items that could affect capital requirements (like Basel III), some have speculated that a new “expected loss” model might not be in place until 2015 or 2016.
How to Prepare
Given that the guidance is yet unclear as far as what it will entail and when it will be implemented, there are no immediate steps an institution should take to modify its methodology. It does, however, make sense for a financial institution to review its process, methods and infrastructures now. For example, current spreadsheet models may pose challenges in this regard, as they may need to be significantly overhauled to accommodate the changing guidance.
The allowance has been a rising source of frustration for bankers in the last several years, as reporting and documentation requirements have grown more onerous, and it is not clear whether the new guidance will make this any worse. Change is always painful initially, but time will tell whether the new guidance helps in avoiding some of the issues of the past or simply presents a new and different set of challenges.
Mike Lubansky is a director of consulting services at Sageworks, where he oversees product development, market research and implementation in the financial institutions market. He has worked on implementation of ALLL methodology with over 100 financial institutions ranging in size from less than $50M to more than $20B in assets. He has delivered presentations to over 200 examiners at FFIEC educational conferences and has been cited on various financial topics in media outlets including American Banker, Wall Street Journal, Bloomberg TV, and USA Today.
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