For years, experts have emphasized the importance of preparing early for the implementation of the current expected credit loss (CECL) standard. CECL “analysis paralysis” has plagued many financial institutions, delaying banks’ and credit unions’ ability to get started quickly. Now, nearly a year out since the effective date for SEC filing institutions, the importance of making early implementation decisions continues to be a leading indicator of CECL success.
Many institutions can get caught up in the unknowns of CECL. Add a sudden global pandemic to the mix, and the uncertainties became even more persistent. During a recent Abrigo CECL Symposium, Reagan Camp, Managing Director of Advisory Services at Abrigo, Gordon Dobner, Audit Director at BKD, and Mike Gullette, American Bankers Association SVP, addressed the most common questions they see in the field and worked to allay apprehension surrounding the new accounting standard.
Documenting decisions is paramount
As an auditor, Dobner reminded financial institutions that the “perfect solution” doesn’t exist; however, making decisions and documenting why the institution made its decisions is paramount. “I think the institutions that I’ve seen that have done the best in this situation were those that were able to make decisions,” he said during the panel. “A lot of people did a lot of good work in terms of having discussions, committee meetings, talking about all of their options. But at some point, you have to make a decision.”
Of course, much of the hesitation around making decisions comes with the need to forecast into the future with CECL, which is not a component of the incurred loss model. Where most institutions struggle during an audit, Dobner said, is from a documentation standpoint. When an institution is working through determining methodologies and models and analyzing outputs, it’s important that they are documenting each decision that they make. Dobner recommends detailing the following deliberations:
- What were you considering?
- What were your assumptions?
- How did you address those assumptions to the standard?
- Which methodologies did you test?
“Those are the areas we really saw those who did a better job separate themselves,” Dobner said. “As an auditor, that is the biggest challenge: Can we understand why you did what you did under this standard?”
Auditors understand that there will be many unknowns, and it’s okay to not have all of the answers. Simply disclose and acknowledge those uncertainties, but don’t let the unknowns “paralyze” the institution and prevent it from getting off of the starting line.
Economic variables, forecasts, and reversions
One of the most challenging pieces of CECL is the forward-looking components. Trying to assess what the future will hold is difficult – just look at 2020. While the economic variables do vary, there is a “common cast of characters,” according to Dobner. Unemployment rates – national or state-wide – are one of the most popular variables used. Other common indicators include GDP (especially as a recession indicator), housing price indexes, commercial property rate indexes, and C&I interest rates. And just how many variables do institutions want to use? For most, two to three indicators are the sweet spot. If an institution uses more than three, it risks duplicating impacts. If an institution chooses to do two or three variables, it may want to consider how those variables might change by pool.
This year certainly makes selecting economic variables particularly challenging. Traditionally, unemployment rate was one of the strongest factors tied to expected or recognized losses. While unemployment rates spiked to a record 14.7% in April this year, the subsequent stimulus packages have prevented – or at least postponed – expected defaults.
“Was it wrong based off of the information we had to tie [the forecast] to unemployment rate? No, but our eyes have been opened to say, ‘Well, maybe there’s more there,’ and you might look at effective unemployment rate or something to adjust for that,” Camp explained.
Many institutions also have questions regarding the length of the forecast period. After looking at nearly 120 community financial institutions, or institutions with less than $50 billion in assets, Dobner found that nearly two-thirds of those banks and credit unions forecasted one or two years.
“I think that had a lot to do with people looking at the business cycle. They’re saying ‘Hey, we’re at the tail end of this expansion period, and we’re less comfortable about how much longer this forecast can really go,’ so they might have picked a year.”
Similarly, on the reversion side, a one-year forecast tends to be the most common, according to Dobner’s experiences so far. Gullette does recommend talking to lenders to help guide the reversion period, especially if an institution is considering a quick reversion period. For example, you may be thinking that we are in a six-month recovery. Meanwhile, a lender might say they will be giving one- to two-year extensions on hotel loans, Gullette explained. A longer reversion period builds in some of the uncertainty on the length of the recession. Regardless of whether we are in a V-shaped, W-shaped, or K-shaped recovery, each expert emphasized the importance of being nimble and flexible with forecasting and modeling.
“It’s not a one-time, set it and forget it deal. You’re probably not changing it every period, but you’ve got to have some framework to look at,” Dobner said.
Reassessing variables, forecasts, and reversions should be a continuous process, and those factors will likely continue evolving. While the pandemic certainly complicated the process, it didn’t fundamentally change anything about CECL.
“The pandemic is really a catalyst, showing us that we have to have this continuous, flexible process,” Camp said.
Partner with those who have gone through it
If an institution is still worried about the unknowns or is still waiting to get started, consider partnering with those who have gone through it. There are many advisors and experts who have worked through hundreds of CECL implementations to this point, and these partners can help institutions see the forest for the trees, so to speak.
“We can quickly take the 31 flavors of Baskin-Robbins and narrow it down to the strawberry, chocolate, and vanilla and say, ‘based off of your makeup, this is what we think might work well, and that’s where you should start,’” Camp explained.
While a number of unknowns remain, the best thing your financial institution can do is to get started. There are tools and groups to help if you feel overwhelmed, but procrastination is no longer an option. Need some additional help getting off the starting line? Learn how Abrigo can help!
About the Author
Kylee Wooten is a Content Marketing Manager at Abrigo.