The Financial Accounting Standards Board’s (FASB) Accounting Standard Update (ASU) 2016-13, or the “Measurement of Credit Losses on Financial Instruments,” requires banks to implement a new method for recognizing their credit losses, called the current expected credit loss or CECL method. According to this accounting standard update, the CECL method will apply to financial instruments that are carried at amortized costs, such as trade receivables, reinsurance receivables, and debt securities that are held to maturity. In addition, it also covers finance leases, as well as off-balance sheet credit exposures that are not taken down as either derivatives or insurance contracts. Some examples of these are loan commitments and financial guarantees.
If the CECL method sounds somewhat unfamiliar to you, take some comfort in the fact that you’re in the same boat as many chief compliance officers and other decision-makers for smaller banks. The standard itself has experienced some delay in its expected implementation for constituent companies. From an implementation target of 2020, the FASB now projects a more realistic 2022 or 2023 deadline for private entities. All the same, it may prove highly beneficial for you to be an early adopter, both for regulatory reasons and reasons of strategic capital management. Here’s what you need to know about how this new standard will affect banks, and why it’s a good idea to invest in regulatory reporting software that will help you account for the CECL on your bank’s financial instruments.
What The Newest CECL Guidelines Mean for Financial Institutions
The easiest way to explain the impact of the new CECL method is to compare it to the loss calculation method that banks have depended on until now. Many banks are used to the loss calculation method introduced by the Generally Accepted Accounting Principles (GAAP), otherwise known as the incurred loss model. That means the institution’s loss reserves are only recognized after the fact, or when a loss has already likely occurred.
In contrast, CECL is a more rigorous standard that requires constituent banks to calculate all losses expected over the life of each financial instrument upon its origination or acquisition, unless the bank takes the fair value option on the instrument in question. Thus, CECL can be looked upon as a preemptive counterpart to the incurred loss model’s reactive assignment of credit loss.
Of course, there are significant implications to calculating this loss differently than before. First, in light of larger loss expectancies, banks may increase their allowance for loan and lease loss reserves by up to 50%. Second, the bank’s product pricing strategies will likely change as a result of the higher capital cost. Third, both the bank’s short-term and long-term loss modeling for each of its instruments will be different from the previous years. And fourth, given the added complexities in the calculations, there’s no doubt that banks’ compliance teams will find regulatory reporting even more strenuous.
Using Advanced Analytical Applications to Master Current CECL-Related Challenges
FASB allows banks some legroom about which measurement approaches to use when calculating CECL. But even this freedom can be extremely taxing on bank compliance officers who don’t know which calculation methodologies to use, and may be anxious about finding an approach that best allows them to justify their data to their regulators.
The key may lie in new digital infrastructure that allows banks to choose suitable models and flexibly account for the expected credit loss on all the instruments involved. A bank can invest in a platform with calculation and analysis abilities for different methods, like roll rate, net loss rate and hazard rate. The preconfigured nature of the system can ultimately make the calculation and analytics processes easier and more traceable. Moreover, the infrastructure may enable granular-level analysis of credit loss according to particular risk characteristics. These include the payment status on the asset, its internal and external credit scores, its effective interest rate, the home industry of the borrower, and the like.
Onboarding new infrastructure for your CECL compliance may also help your bank strengthen its reporting foundations for the different standards that involve the interrelated issues of CECL, risk reporting, and capital planning. These include IFRS 9, BCBS 239, DFAST, and CCAR among others. A dedicated regulatory reporting solution will essentially allow you to keep a single source of reporting truth, which in turn will serve as an accurate and streamlined basis for your future financial reports.
Toward a Cautious Future: Making Careful and Accurate Projections with the CECL Method
Banks that intend to comply with FASB’s CECL guidelines soon must have sufficient infrastructure to calculate and report their expected credit losses according to this new standard. If your bank becomes one of these early adopters, you’ll be able to enjoy the fruits of CECL compliance—greater financial transparency, a more stringent auditing process, and capital management strategies that will take your institution through its rainiest days. Assess your current data and system requirements for achieving CECL compliance, and upgrade your bank’s reporting capabilities in time for 2023.