CECL’s Road to Implementation and its Potential Effect on the Economy

By Ryan Abdoo, Plante Moran

With FASB’s Financial Instruments Project expected to be finalized in the first quarter of 2016, the new current expected credit loss model (CECL) is on the minds of all of us in the financial institutions industry. One area of focus remains the requirement to forecast expected losses and how an institution is going to support that forecast. As with anything new, the first few reporting periods are likely to be filled with uncertainty and debate among regulators, auditors, and management.  But could there also be an overall concern with the potential impact on the general economy?

Back in the “old days” of calculating the allowance for loan loss, the industry’s primary ratio of consideration was the allowance for loan losses as a percentage of loans. And with that ratio, wasn’t it amazing how so many institutions had somewhere around 1.25 percent of total loans in the allowance? Well, that ratio probably wasn’t a coincidence, as regulatory capital provisions include a formula that served as the baseline for that ratio. Under the former and current capital adequacy rules, banks are allowed to include the allowance for loan losses up to 1.25 percent of risk weighted assets in capital.

Many in the industry expect that allowance for loan losses will need to be substantially increased as a result of CECL.  The question that remains is whether the regulatory agencies will provide a form of relief. If that doesn’t happen, and allowances are required to significantly increase upon adoption of the CECL standard, some institutions and, potentially the industry as a whole, could be affected with the instant removal of all that capital from the market.

The industry and even the overall economy could face headwinds as institutions evaluate the effect of the new requirements and how they will ensure they maintain compliance with the capital standards set forth by BASEL III.

While banks await the final standard, they can still start thinking about implementation based on the draft proposal.  Here are some questions to consider:

• How will the loan portfolio be segmented to create pools with at least two similar credit risk characteristics?
• How will the vintage of loans be factored into the loan pools?
• What data is available to estimate the average life of the loans within the identified pools?
• How will historical loss data be determined and tracked for each loan pool?
• How will credit losses be estimated for each pool?  While not a requirement, is the institution positioned to develop and implement a probability of default model or migration analysis model?
• What economic data can be gathered to help support the economic cycles within the institution’s lending area, commensurate with lending activities?

Editor’s Note: Ryan M. Abdoo, CPA, is a senior manager at Plante Moran in Chicago.