Written by: Jeff Morris, ProBank Austin
Financial Institutions of every size, whether public or private, are continuing to invest time, effort, and resources into their preparations for CECL, as implementation dates draw nearer for the largest single accounting standard change to hit the financial services industry in decades.
Numerous individuals inside every institution, including board members, C-level executives, Lenders, Risk and Compliance Officers, IT specialists and others are scouring every available piece of written guidance, having discussions with accountants and regulators, attending webinars and interviewing solution providers in attempts to adequately prepare for the implementation of the new Current Expected Credit Loss standard (ASU 2016-13) when it officially takes effect at the beginning of Q1 of 2020, 2021 or 2022 depending on the nature of each individual institution. Major topics requiring study include new and expanded data collection requirements, policy writing, loss forecasting model development and governance, mastering loss estimation methodologies, internal controls, model validation requirements, and more.
Under CECL, nearly everything about the way a financial institution calculates its Accumulated Credit Loss, changes. The recognition of loan losses moves from waiting until a loss is “probable of having been incurred”; to recognizing all future expected credit losses on the day the loan is made. Effectively, the loss recognition period transitions from a single year only, to a full life of loan perspective. The focus of the institution in attempting to appropriately measure credit losses has shifted from a review of historical and current conditions, to more of a focus on future events, including reasonable and supportable forecasts of losses expected to be incurred long into the future, and occasionally as much as 5 – 10 years into the future, in some cases.
At least one thing stays the same under CECL, and that is the fact that management will still consider how various factors affecting loss rates in the past may be different in the future and adjust their estimate of loan losses based on these factors through a process known as Qualitative Adjustments, or QA factors. (A list of commonly used QA factors is included in a sidebar table within this article).
During the past several years, while the banking industry has been experiencing a historically low rate of credit losses, the impact of Qualitative Adjustment factors has been of increasing importance in the determination of a financial institutions total recognized loan losses. In some instances where institutions have temporarily experienced either no Charge-Offs at all (not an entirely uncommon finding over the past several years), or have experienced Net Recoveries, (a situation where, within a given year, Recoveries of prior Charged-Off amounts exceed current period Charged-Offs on loans), 100% or more of any loan losses recognized may be the result of Qualitative Adjustments applied by management. In other, more common cases, where institutions may be currently experiencing Net Charge-Offs far below longer-term historical averages, it has not been the least bit uncommon to see institutions with 50 – 75%, or more of their total recognized loan losses, (under the current Annual Incurred Loss method), resulting from the application by management of a variety of Qualitative Adjustment factors.
With this common understanding of the current environment as a back drop, it might be useful to consider how the current Qualitative Adjustment factor process might change, (or need to be changed), under CECL?
The purpose of Qualitative Adjustment factors has always been to provide management with a means to take into account expected changes in environmental factors potentially having an effect, up or down, on the level of recognized loan losses, that, for whatever reason, fail to show up in the Quantitative Analysis performed by the Institution in determining its base loan loss rate.
We would suspect that this purpose will remain constant as financial institutions transition from the Annual Incurred Loss Rate method to CECL; however, it is very likely that there will be a significant shift in both the process of determining Qualitative Adjustments, as well as in theamount, and perhaps even the direction of Qualitative Adjustments under CECL. For this reason, we think it is important for financial institutions to consider the Qualitative Adjustments they will first apply within their initial parallel runs of their new CECL models, and resist the temptation to simply carryforward the existing Qualitative Adjustment factors from the current Annual Incurred Loss Rate models, into their new CECL loss forecasts. There are a number of reasons why we think this will be the case.
For the purposes of our discussion, it would be helpful for us to think of the total estimate of loan losses, whether under the current Annual Incurred Loss Rate method, or under CECL, as consisting of two parts, a base loss estimate, plus or minus the impact of any Qualitative Adjustments.
Given this understanding, it is important to consider that the base loss estimate, (the number that the QA factors seek to adjust), are not being calculated on a similar basis between the two methods. Under the Annual Incurred Loss Rate method, the base loss estimate is, as its title suggests, a single year loss estimate, whereas in the future under CECL, the base loss estimate will reflect all of the losses expected to be incurred over the life of the entire loan portfolio, which we’ll roughly estimate to average something between 3 and 6 years, depending on the mix of loans within any given institutions portfolio. For simply this reason alone, it should be apparent that a straight “drag and drop” of your current QA factors from your existing Annual Incurred Loss Rate model, straight into your initial CECL model, will not work, and in nearly every case would result in a significant overstatement of your loss reserve requirement.
Although our main point has probably already been sufficiently clinched, there are other good, logical reasons why each institution will likely want to begin its Qualitative Adjustment factor process under CECL from a clean sheet of paper.
Let’s consider once again the base loss estimate, (again, the number you are seeking to adjust with your QA factors), and another way that it is different under the current Annual Incurred Loss Rate method than it is under CECL, with respect to the differences in loss emergence periods under these two methods. In the past, when you have applied a QA factor to the base loss estimate of the Annual Incurred Loss Rate method, you were thinking only of a one year forward adjustment, and adjusting a loss rate that may have reflected a 1, 3 or 5 year(s) of history, depending on your selection of relatively comparable historical periods in comparison to your current loss experience.
Under CECL, your QA factors will more likely be determining the required adjustments based on a lookback period equal to the life of the loan portfolio (let’s assume a three to five year period), and comparing the conditions that existed during that lookback period, to your reasonable and supportable forecasts of the future 3 – 5 year period representing the life of the loan portfolio, moving forward.In other words, the Qualitative Adjustment factors you’ve used in the past, also don’t work under CECL, because the time periods you are attempting to compare are significantly different in duration, and therefore you cannot assume that conditions during these time periods will be similar.
Our final recommendation on this topic to financial institutions preparing for CECL is to not look at this requirement to rework your Qualitative Adjustment factor process as a bad thing, or as simply more work required to get your CECL model up and running. Rather, this is an opportunity to more appropriately and correctly assess the base loss estimates emanating from your new CECL model and the environmental conditions driving these losses, both in the past and over your forecast period.
Reworking the Qualitative Adjustment factor process and amounts is your chance to put managements unique experience and insider perspective on the Current Expected Credit Losses of your institution, and to enhance the credibility and accuracy of your CECL loss estimates.