CECL: Everything You Need To Know
In 2016, the Financial Accounting Standards Board announced that they would change the methods financial institutions used to calculate and report charge-offs. This new regulation changed the method from an Allowance for Loan and Lease Losses model to a Current Expected Credit Loss model. Under the Allowance method, credit unions charged-off loans when they occurred, but under CECL they are expected to forecast potential credit losses and acknowledge them in the moment. This has ramifications for provisions and allowances and has created some confusion amongst financial institutions. This resource looks to clear that confusion.
What is CECL?
- Current Expected Credit Losses (CECL) is a FASB-directed change in accounting standards that requires credit union charge-offs to include expected future credit losses and adjust their allowances and provisions accordingly. FASB believes it gives regulators better insight into credit losses at financial institutions during periods when a forward look at credit loss exposure is warranted.
What are Charge-Offs and Allowances?
- Charge-Offs: Failed loans and investments. If a member stops making payments (is delinquent) on a loan for an extended period, it is likely that the loan will charge-off. This creates an asset loss for the credit union and hurts earnings, which negatively impacts overall membership.
- Allowance Account: To account for the always-present risk of charge-off, credit unions set aside a portion of their earnings into a special savings account called an “allowance”. When a loan/investment fails, the credit union takes money out of this account to “cover” the loss.
What Must Credit Unions Do to Comply?
- Credit unions are expected to develop, or outsource development of, models for forecasting future credit losses and aggregating them to help regulators understand in the present what future credit loss exposures may be. It takes allowances from a probable loss model to a possible loss model.
What is Different From Before?
- Regulators are forcing a transition from a PROBABLE loss model to a POSSIBLE loss estimate
- Probable = certain individual loans and investments are in bad standing. Credit unions must cover them with allowance.
- In fact, credit unions were NOT allowed to reserve for assets that were in good standing in the moment, even if you knew they were likely to fail. Setting aside too much allowance could be construed as a drain on earnings and capitalization.
- Possible = credit union managers must “guess” what is LIKELY to go bad given future assumptions and set aside money to cover this expectation.
- Now credit unions are expected to come up with their own estimation model about what they predict will happen.
What conditions does each institution’s CECL forecasting model need to meet?
- Under CECL, credit unions can develop their own models for CECL estimation. However, they must be well documented around three conditions. CECL estimation models must factor in relevant information about past events, including (1) historical experience, (2) current conditions of the macroeconomy and the lending portfolio, and (3) reasonable and supportable forecasts that affect the collectability of the reported amount.
Does the NCUA have any resources for developing a CECL estimation model?
- The NCUA has developed a Simplified CECL Tool that utilizes the Weighted Average Remaining Maturity (WARM) method for calculating projected charge-offs. It is geared primarily for credit unions with less than $100 million in assets that have less complex pools of loans and investments. The WARM method uses the average annual charge-off rate and multiplies it by the amortized adjusted remaining life of loans and investments to calculate the lifetime historical charge-off rate for the pool. From there it aggregates forecasted credit losses and carries them forward.
- In layman’s terms: this is a simple method of projecting the amount of assets that are likely to charge-off by looking at past performance and applying those past results to the current composition of the asset portfolio.
Which financial instruments are covered by CECL?
- CECL covers any financial instrument carried at amortized cost including loans held for investment, net investment in leases, held-to-maturity debt securities and others. It also includes future charge-offs for off-balance sheet credit. For a full list, please see the NCUA’s CECL Resources.
Which credit unions are required to comply with CECL?
- Credit unions under $10 million in assets are exempt from CECL compliance unless expressly required by State Supervisory
Will Callahan provide CECL resources in Peer Suite? And how will CECL impact my analysis?
- Callahan does not plan to create CECL displays in Peer Suite. CECL will impact analysis in Peer with provisions for credit losses and allowances for credit losses. Provisions and allowances prior to CECL will reflect the pre-CECL method of calculating charge-offs. Starting in 1Q23 provisioning practices will reflect the CECL model of future forecasting. Net worth ratios may also be impacted by these swings. Furthermore, credit unions under $10 million may not have adjusted their provisions and allowances as they are not required to by the NCUA.
How will CECL impact net worth?
- Bringing credit losses forward will impact net worth. Due to this, the NCUA allows credit unions to “boost” earnings over the next two years, slowing phasing them out to give time to build up capital.
What are the pros of CECL?
- CECL gives regulators the ability to understand potential credit losses ahead of financial crises. In a probable loss method, FASB deemed that allowances were often “too little, too late” as financial institutions had a difficult time accurately assessing the need for future allowances. Charge-offs were reported “pro-cyclically”, which means they were reported in line with the business cycle.
What are the cons of CECL?
- CECL is reliant on management’s forward-looking understanding of key economic factors, and how those apply to the current portfolio. Management may not be able to include all relevant information in the estimation model.
- Modeling will make comparisons between financial institutions difficult. Because each estimation model will be at least slightly different, regulators will be comparing figures that are arrived at via different methods.
- Credit unions must devote analytic resources to an area that previously did not require much attention. For smaller credit unions, the NCUA developed a simple tool, but mid-sized credit unions may be forced to outsource this capability. Many large credit unions will spend valuable member resources to develop approved models internally.