The last three months have brought an influx of responsibilities and challenges for bank and credit union CFOs to consider. As if CFOs didn’t have enough to focus on already with reporting tied to financials, asset/liability management, strategic planning, and enhancing the bottom line, the pandemic stormed in as 2020 was off to a solid start. After the longest economic expansion in U.S. history, the pandemic has quickly and dramatically impacted our lives and economy. Federal and state governments have passed new legislation to help mitigate the economic impact from the coronavirus, including the SBA’s Paycheck Protection Program (PPP). The PPP, with all its nuances and requirements of financial institutions, has also brought new and different concerns to bank CFOs as they support local businesses throughout this uncertain time. Given the many competing priorities, the long-awaited current expected credit loss (CECL) update, has likely taken a back seat at many institutions, but there are still many important CECL-related considerations to be made.
CECL delay and updates
The CECL effective date is not delayed, nor have effective dates for CECL adoption been changed. Rather, financial institutions that adopted CECL as of Q1 2020 have an option to delay the presentation of the impact of CECL on their financial statements. The CARES Act in March allowed the presentation delay until the earlier of the end of the pandemic (yet to be defined) or Dec. 31. Therefore, CFOs of SEC-registered banks that had implemented CECL on Jan. 1 must remain mindful of the pandemic’s impact. Even banks that remain on the incurred-loss model and have a 2023 deadline should not lose sight of CECL.
With 2020 disrupted by the PPP and other efforts to help small business customers stay afloat, a bank’s previous timeline for assessing data gaps and taking other steps to be prepared by 2023 could face serious delays without a concerted effort to get back on track. Financial institutions will need to continue to run their CECL calculations throughout 2020 in order to determine the impact and retroactive adjustments necessary. Banks will need to restate the allowance for the periods from Q1 2020 up to the end of the delay.
For banks calculating the allowance for loan and lease losses (ALLL), 2023 remains the deadline, despite calls for additional CECL implementation delays. Administratively, CFOs will need to balance their time between handling the pandemic-related issues of 2020 and staying on track with institutional goals for completing data analysis, selecting methodologies, validating models, and making adjustments over the next 31 months.
Loan modifications and workouts
For lenders reporting under both the expected-loss and incurred-loss models, an increase in loan workouts or modifications may wind up as unwanted impacts on the allowance. With the pandemic, the PPP, and deferments of P&I payments for three months, six months and some longer, workouts will loom on the horizon over the next couple of years. These workouts may be large and more than we have seen in recent years, considering that workouts have been minimal or isolated to specific borrower circumstances.
It will be necessary for credit professionals to gear up their workout area and dust off their policies and procedures, but how will these workouts impact the allowance? The impact will be felt in an increase in troubled debt restructurings (TDRs) – nonperforming at first until a track record of payments is achieved, but still a TDR, nonetheless. This will require an analysis of the concessions granted in the modification agreement and most likely, a discounted cash flow analysis, due to the concessions, to determine the value of the loan. If similar concessions are granted pursuant to a loan modification program for certain types of loans, alternatively, these loans may be pooled with a reserve calculated at the pool-level. Keep in mind that the concessions would typically need to be part of an overall program for these loans that are selected for pooling.
A caveat to this normal treatment, however, is that because of the pandemic, regulators and the FASB have agreed that short-term loan modifications tied to the pandemic do not have to immediately count as troubled-debt restructurings. That creates another layer of complexity in determining TDRs.
Qualitative and forecast components
Prior to the pandemic and subsequent economic impact, financial institutions had been experiencing a strong economy with minimal losses and problem loan trends, and their qualitative adjustments should have been minimal. Certainly, both current qualitative as well as forecast conditions will require significant adjustments to reflect the deteriorating economic conditions seen over the last few months and probably continuation at least through the remainder of 2020. Banks will likely experience the impact of worsening conditions (problem loans) longer than originally predicted in early 2020, so it will be important to consider the longer horizon for the forecasting component in ACL calculations.
With CECL’s life-of-loan concept, the adjustment will be more significant than under the current incurred loss model. This will need to be recognized when adjusting for current and forecasted conditions that are not reflected in quantitative models. Historical models would not support any current conditions and those likely to be experienced, unless the institution has data back to the Great Recession and was negatively impacted by it. The Great Recession resulted from a financial crisis. What is so different about the current crisis is the uncertainty of the end or at least the turning point of a health pandemic that we have not seen in our generation’s time. Until major economic indices, such as unemployment, improve, the CFO will need to reserve for risk associated with current economic conditions as well as risk related to the economists’ forecasts of pertinent indices.
Given deferments, institutions are not currently experiencing stress in their loan portfolios (e.g., non-accruals, significant past-dues). However, as months go by, the CFO should be prepared to make changes to qualitative adjustments and forecasts to accurately reflect conditions and future risks, such as delayed business openings or low consumer support, stress in oil prices and other segments, and industry stresses such as hospitality as well as deferments ending. While counterintuitive, the CFO may want to extend the institution’s forecast horizon, primarily because the loan portfolio may not be impacted until later and this impact will be protracted as deferments and government support programs end.
Paula King, CPA, Senior Advisor with Abrigo, has held executive positions, including as Chief Financial Officer, in the banking industry for more than 25 years. As a former CFO, she has extensive experience in the design, preparation and reporting of the allowance for loan and lease losses, including ensuring compliance with regulatory and audit requirements, and creating allowance policies, procedures and processes. Paula has been responsible for SEC and financial reporting, capital raising efforts and strategic planning, and has served as a Chief Risk and Compliance Officer. She has been responsible for overseeing daily operations for several banks and frequently served on internal credit committees. She co-founded a bank and served on its board of directors through its merger with another financial institution and has been a de novo bank consultant to boards and senior management teams.