Written By: MEBiery
A hallmark of the Financial Accounting Standards Board’s shift from the incurred to current expected credit loss model, or CECL, is that banks and credit unions will begin estimating credit losses for the entire life of the loan, instead of just what has already been incurred as of the calculation date.
In that regard, bankers who wonder how far into the future they must estimate future credit losses under the updated standard should look to the contractual terms of the asset. As Sageworks Executive Risk Management Consultant Tim McPeak notes, however, the contractual terms only provide one piece of the answer to the question, “How far is far enough?” Institutions will need to factor in their expectations for prepayment and refinancing behavior in their view of the life of the loan under the updated standard, which goes into effect for SEC-registered financial institutions in 2020 and for all others in 2021.
“So if I have a 30-year mortgage, for example, I’m probably not going to use 30 years, even though that’s the contracted life, because in all likelihood, the lifetime of the loan will probably be seven or eight years because people will prepay and refinance,” McPeak says.
In addition, the CECL model incorporates an institution’s expectations for how future conditions might affect losses. As described by the FASB in a recent newsletter:
“The measurement of expected credit losses is based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount.” (italics added for emphasis)
However, as the comment above notes, forecasts incorporated into the allowance for loan and lease losses (ALLL) must be “reasonable and supportable.” In fact, the FASB specifically said, “Organizations will not need to forecast economic conditions over the entire contractual life of long-dated financial assets if those forecasts are not supportable.”
So how far into the future should “reasonable and supportable forecasts” look?
“A lot of financial institutions are asking this,” says McPeak. The standard does not specify a timeframe.
“The market has seemed to latch onto the idea that two years is the most common thinking,” he says. “I’ve heard some say three years, but that seems like that would be at the outside edge.” Beyond that, forecasting four years and longer seems difficult and may not yield useful results, according to McPeak.
The standard at 326-20-30-9 says:
Some entities may be able to develop reasonable and supportable forecasts over the contractual term of the financial asset or a group of financial assets. However, an entity is not required to develop forecasts over the contractual term of the financial asset or group of financial assets. Rather, for periods beyond which the entity is able to make or obtain reasonable and supportable forecasts of expected credit losses, an entity shall revert to historical loss information … that is reflective of the contractual term of the financial asset or group of financial assets. An entity shall not adjust historical loss information for existing economic conditions or expectations of future economic conditions for periods that are beyond the reasonable and supportable period.
One thing to keep in mind, McPeak notes, is that the way forecasting is manifest will probably be closely tied to the methodology an institution uses for the ALLL. Financial institutions will want to document their accounting policies and methodology, and that documentation should include the factors that influenced the forecasts about the future.
In other words, thorough documentation will be critical in developing the “supportable” component of “reasonable and supportable forecasts.”