CECL is Coming – Is Your Institution Ready?

By Joseph Jalbert September 13, 2022

As institutions’ hopes of another deferral by the Financial Accounting Standards Board (FASB) wane, a stark reality is setting in: CECL adoption is right around the corner. While change can no doubt be unsettling, it is those institutions that have made use of the significant runway afforded them by the FASB that will be best prepared to adopt the new standard with confidence. That said, institutions feeling like they’re in “scramble mode” still have time, albeit limited time, to push forward and develop a model that will be compliant with the new standard and hold up to scrutiny by auditors and regulators. This article is intended to provide some last minute reminders and considerations to those racing to the finish with their CECL implementation efforts.

If you haven’t adopted CECL yet, you won’t be the first. Institutions that have yet to adopt the new standard (Accounting Standards Codification (ASC) 326) can leverage the lessons learned from the early adopters, i.e., large public filers (my colleague, Spencer Hathaway, previously published an article on this very topic that can be found here). What can we glean from these institutions’ CECL journeys? For one, many early adopters indicated they wished they had started the process sooner. Along those lines, if your institution is planning to use a more complex methodology, expect that more time will be required to develop it. If your institution is small with a non-complex portfolio and you’re under the gun, use of a less complex method is generally recommended if you can support its application (including having the data necessary to apply the chosen method…more on that later).

There is no “right” answer to CECL. There is a common misconception that institutions will be expected to get to a certain level of reserve under CECL. This is not the case; rather, the use of appropriate quantitative inputs and well-supported assumptions will drive the result.

Complete and accurate data is critical. As institutions consider the various methods available to them under the new standard, the first question that should be asked is: Do I have the data necessary to apply this method? If the answer is “no,” that method should be removed from consideration, as availability of data that is complete and accurate is one of the most critical aspects of a sound CECL model. Institutions should develop processes and controls to ensure this is the case.

Documentation, documentation, documentation. As auditors, we love documentation. Our clients, however, don’t always share in our affection for it. We get it – our clients are busy and documentation can be time-consuming. As it relates to your institution’s CECL journey, however, we can’t stress enough the importance of sound documentation. Maintaining quality documentation will demonstrate to auditors and regulators that management was thoughtful in its approach to the new credit losses standard. Which methods did management consider and which method(s) was/were ultimately selected, and why? What is management’s basis for how the portfolio is segmented? How are qualitative factors and forecasts developed, and how does management support their reasonableness? These are just a few examples of areas where strong documentation will serve institutions well.

Don’t forget to have your CECL model validated. Regulatory agencies expect institutions to maintain sound model risk management programs that address three key elements: 1) model development, 2) model validation, and 3) model governance. As it relates to CECL, institutions should ensure their model is thoroughly validated prior to implementation of the new standard and on some regular cadence going forward. These validations may be performed internally or externally, but whoever is performing the validation will need to be qualified and independent of the model’s development.

Understand the impact of various inputs on the end result. Certain inputs into the CECL model will have a greater impact on the calculated reserve than others. For those highly-sensitive inputs in particular, it would be wise for institutions to assess the impact of changes to these inputs and ensure those that are ultimately selected are well-supported. A change to prepayment rates, for example, can have a meaningful impact on the calculated reserve. Institutions should understand this impact and be prepared to defend the rates utilized within their model.

It’s not just your loan portfolio that is impacted by ASC 326. While institutions’ loan portfolios are rightly top of mind when it comes to the new standard, don’t forget the other financial instruments that are impacted. Institutions will need to apply the CECL model to held-to-maturity (HTM) investment securities, another class of financial instruments measured at amortized cost. Those institutions whose HTM securities are limited to U.S. Treasury securities and/or securities issued by government agencies or government-sponsored enterprises generally won’t need to develop as robust an analysis as an institution holding securities with an expectation of larger losses (e.g. private-label collateralized mortgage obligations, corporate debt), but should prepare a documented analysis nonetheless.  

 Although the CECL model does not apply to available-for-sale (AFS) securities as they are carried at fair value, the new standard removes the concept of other-than-temporary impairment and transitions to a valuation allowance approach whereby institutions will establish a valuation allowance against securities with expected credit losses and will increase or decrease the valuation allowance on a prospective basis as expected credit losses improve or deteriorate.

Similar to the requirements under existing guidance, institutions will need to calculate a reserve for unfunded commitments. Similar to on-balance sheet exposures, however, institutions will now apply the CECL model to its unfunded commitments and measure expected credit losses on a pool basis when similar risk characteristics exist. The reserve should be calculated by estimating credit losses on unfunded commitments that are not unconditionally cancelable over the contractual period the institution is exposed to credit risk.

The Final Push

 ASC 326 requires institutions to completely overhaul their incurred loss models to which they’ve become so accustomed over the years. This is no easy feat; transitioning to an expected loss model requires careful planning, data analysis, and changes to existing policies and procedures, among other things. The list of above considerations, while intended to be helpful, is by no means an exhaustive list of the elements of the new standard institutions will need to consider. Given the extent of the new standard’s requirements, it is critical that institutions use the last remaining months before implementation to move forward with the development, testing and refinement of their models. Those that do are more likely to avoid headaches in a post-adoption world.

As a reminder, ASC 326 is effective for all entities other than public business entities that meet the definition of an SEC filer (excluding entities eligible to be smaller reporting companies) for fiscal years beginning after December 15, 2022. Early adoption is permitted.