Over the course of the next several years, any number of aspects of the financial industry can change. Information security could become tighter to better protect a financial institution’s sensitive data, or restrictions could relax allowing more credit union members access to lines of credit for mortgages or auto loans. One critical change in the landscape, though, isn’t member-facing – transitioning from the incurred loss model to the expected credit loss model in a credit union’s allowance for loan and lease losses (ALLL).
The Financial Accounting Standards Board (FASB) issued the final guidance on their Current Expected Credit Loss (CECL) model on June 16, and will be effective for credit unions beginning for fiscal years after December 15, 2020. This back-end calculation adjustment isn’t one that members will see reflected on their monthly statements, but it will likely impact credit unions going forward.
While it is common for credit unions and banks to adapt to many regulatory changes, it is rare for those changes to impact the ALLL. In fact, institutions calculate their ALLL now based on well-established accounting and regulatory standards that have had only minor changes and updates over the past several years.
Simply put, the allowance is an element of risk management that financial institutions have to get right, and it is likely that CECL will change the loan loss reserve calculation and could have implications across many aspects of day-to-day operations.
A chief criticism of the existing ALLL model is that it relies too heavily on outdated information; institutions recognize credit losses only once they are considered “probable” instead of when they are first identified. The dangers with this delay were exposed during the financial crisis, when reserves were insufficient to cover institutions’ losses. The proposed CECL model suggests forward-look analysis and looks at the life of the loan, rather than just one year. The objective would be for institutions to account for and therefore reserve for losses based on “possible” estimates.
CECL leaves many financial institutions speculating how life-of-loan losses can be defensibly predicted using historical and qualitative factors. For many credit unions, particularly smaller institutions, it also raises some concerns about historical data that may not have been recorded or will be inaccessible when it’s needed for a CECL calculation.
All of this information and impending changes to the ALLL begs the question –what can a credit union do now to prepare? Without knowing what the final FASB guidance looks like, the most effective way to prepare for CECL is to be proactive by gathering loan-level data for the portfolio. This includes collecting and storing data such as a loan balance, segmentation for the loan, risk rating, charge-offs and recoveries associated with the loan (partial and full), as well as loan duration. This data may not be needed immediately, but building up a solid history of detailed data will give credit unions the flexibility and resources to adjust their models as needed.
There’s little doubt that back-end processes for credit unions’ ALLL calculations will change over the next several years. By understanding and preparing for these changes, you may save your institution headaches later.