Written By: MEBiery
There is a reason regulatory agencies are directing their guidance on the new current expected credit loss (CECL) model to the attention of financial institution CEOs. After all, it is top management’s responsibility at the end of the day to ensure the allowance for loan and lease losses (ALLL) is adequate. Historically, the chief executive officer and the board of directors have provided oversight and a particular point of view to the overall process to ensure the adequacy of the allowance. Indeed, examiners are instructed to routinely check that management has implemented an acceptable allowance evaluation process.
Under the new credit-losses standard from the Financial Accounting Standards Board, the CEO will continue to have ultimate responsibility for the adequacy of the ALLL. Sageworks Risk Management Consultant Robert Ashbaugh said CECL‘s potential impact on the actual amount of the reserve for loan and lease losses may mean that CEOs also grapple with trickle-down impacts on other financial and strategic decisions. “CECL may materially change the reserve number, which will ultimately affect net income, taxes, dividends and capital,” Ashbaugh noted.
Michael Gullette, vice president for accounting and financial management policy at the American Bankers Association, recently spoke at the Sageworks Risk Management Summit about some of the challenges that CEOs and others in top bank management positions will face as CECL is implemented.
One of the biggest CECL-related responsibilities for CEOs will be communication. CEOs will play an important role in communicating information to investors and the board about the new standard and the related changes underway, according to Gullette. Ashbaugh agreed. “CEOs usually run conversations with the board so they are going to be integral in messaging CECL changes to the Board,” he said.
Investors and directors accustomed to one definition of loss rates will need to understand how estimates under CECL are different. The change to recording provisions for expected losses at origination rather than when it is probable a loss has already occurred will mean a shift in the mindset for interpreting the ALLL. Top management will need to communicate what happened during the reporting period to affect the provision and why the provision may no longer track delinquencies or nonaccrual loans. A number of scenarios (such as new forecasts for improved future macroeconomic conditions and collateral prices or a drop in originations during the period) could result in past due loans increasing but provisions falling.
As Gullette noted at the Summit, the accounting standard says that in order to help financial statement users understand the method and information used to develop the ALLL and to understand the circumstances that caused changes to the allowance, financial institutions must disclose by portfolio type:
“A discussion of the changes in the factors that influenced management’s current estimate of expected credit losses and the reasons for those changes (for example, changes in portfolio composition, underwriting practices, and significant events or conditions that affect the current estimate but were not contemplated or relevant during a previous period)”.
Management of the financial institution
While the changes related to CECL have bankers intensely focused on how the calculations of the reserve will differ from past practices, it’s important to remember that the overarching goal of the new accounting standard is to help financial institutions better manage credit risk as they manage the bank or credit union. CECL, therefore, could have an effect on larger management issues under the CEO’s purview, including capital management, risk programs, credit policies and decisions and even compensation. CEOs and their executive teams can leverage the new information generated through the CECL process to understand better how certain bank activities (such as underwriting and risk ratings) affect credit losses and the magnitude of losses, and to plan for and implement changes as necessary.
As financial institutions learn more about the risks and forecasting, CEOs will be able to convey more confidence in the bank’s loan pricing, lending and strategy – not only to the board but also to investors and other stakeholders.