For CECL, it’s “ALLL” hands on deck: Credit risk management’s role in estimating expected credit losses
Aug 26, 2015
As many bankers know, the FASB’s pending move to the Current Expected Credit Loss (CECL) model from the incurred-loss model is the most significant change in financial reporting for banks in decades. Implementing CECL will require banks to enhance their policies, procedures, and systems in multiple areas, to be sure.
One important key to successfully making the transition will be the increased involvement by credit risk management in developing accounting estimates used for the allowance for loan and lease losses (ALLL), according to Graham Dyer, senior manager in the financial services practice of Grant Thornton LLP.
“The accounting side of the house is used to thinking about how to account for the ALLL,” he said, adding that accounting by its nature is backward-looking. “Historically, though, the credit risk side of the banking back office has not had to have been involved in the nuts and bolts of that accounting – often only providing risk ratings and historical charge off data to their accounting brethren.”
That will change under CECL, which Dyer and others anticipate will be finalized and issued in Q1 of 2016. Accountants developing the ALLL will need to consider not just historical data and current credit risks but also forecasts for future changes in credit risks and trends. “The accounting folks who are creating that estimate of expected losses will need to utilize quite a bit more information from the credit risk side,” said Dyer.
For some institutions, a closer working relationship between credit risk staff and accountants developing estimates for the ALLL will be a dramatic change and one that involves cultural issues that might be tricky to navigate. The sooner credit risk management can work with the institution’s accountants to prepare for these changes, the better, Dyer said.
“The bankers are going to have to talk to the accountants,” said Dyer. “They’re all going to have the opportunity to get to know each other and to learn to appreciate each other’s skill sets better.”
For example, some of the credit risk information that will be a key input for the more forward-looking credit-loss model will be subject to internal controls over financial reporting at institutions that are subject to those requirements, Dyer said.
“Forward-looking credit information is going to become an input to an accounting process, so it’s got to be subject to all of the documentation rigors that come with testing internal controls over financial reporting,” he said. “You’re going to have accountants saying, ‘I understand that’s your expectation for future losses, but what is it based on, and how did you validate it, and where did you document those considerations?’”
“A lot of folks who aren’t in the finance function aren’t used to that sort of scrutiny,” he said. “They’re used to saying, ‘It’s my best estimate,’ so that sort of cultural shift can be hard. When we’re talking to people about the upcoming changes, that’s almost as impactful as everything else. As they’re starting to change these processes, there’s a lot of pushback from the non-finance functions.”
Another example of how bankers will need to work more closely with accountants is in developing economic forecasts to estimate future credit losses, according to Dyer. Institutions already develop forecasts to aid in pricing, stress testing, and capital planning. Those forecasts and the forecasts tied to expected credit losses generally shouldn’t be at odds with each other.
“One thing auditors will be looking for is what forecasts are being used for the allowance estimate, and are those consistent with other forecasts in the bank? If a bank has a rosy forecast for the ALLL and a negative forecast for capital planning, there may be reasons for that, but they’ll have to have those documented and ready to explain. Otherwise, it may look like you have a bias.”
What can management do to make the transition go more smoothly? Dyer suggests the following.
- Good project management. As it is when dealing with other major issues in a business, managing the process from the beginning is important for financial institutions as they implement CECL.
- Make it an integrated, multidisciplinary effort from the beginning. “My dad used to say, ‘Don’t assume anything is possible or impossible until talking to the people who have to do the work,’” Dyer said. Identify what information will be needed to calculate the estimate under CECL, then involve the people who have the information as you develop process flows – not afterward. “It’s not just assuming you know that process will work and where they’re going to plug in,” he said. “It’s having it be an integrated effort from the beginning.”
- Recognize issues and deal with them early. “It’s the old saying, ‘An ounce of prevention is worth a pound of cure,’” Dyer said. “People who wait until later in the process and start grabbing information on an ad hoc basis are going to run into trouble with their auditors and their regulators.”
- Document everything. For example, it’s important to document the process and key controls before the new estimate is “live,” Dyer said.
The good news for staff in all areas of the financial institution is that generating the allowance under CECL is likely to produce a lot of data that can help the bank on multiple fronts, Dyer said.
“The allowance has been something that the accountants spend a lot of time on, and typically, they produce it and really, the only purpose is to have fully compliant financial statements,” he said. “We think there’s a ton of good information – and very expensive information – that will be used to generate the allowance that institutions can use to help manage the institution and analyze the profitability of certain products or certain customers. They’ll be able to look at loss trends by product and say, ‘Are we doing the right sorts of loan maintenance and credit administration? Do we need to change covenants in some of our loan products?”