Planning for Loan Losses in an Unknowable World
Despite a global pandemic and unprecedented regulatory relief, the CECL accounting framework to account for loan losses is here to stay and being implemented as of March 31 for most lenders. How did we get here and what are the implications for capital, technology, and business models? We will explore those questions here.
FASB Holds Firm on CECL Timeline
On March 23, Kathleen Casey, Chair of the Board of Trustees of the Financial Accounting Foundation1, wrote a letter to Congress responding to FDIC Chair Jelena McWilliam’s request to delay CECL implementation. In it, Casey urged leaders to reconsider language included in the Senate economic relief bill proposing to delay the CECL transition. She also strongly urged Senate members to reconsider intentions to suspend compliance with FASB’s guidance surrounding Troubled Debt Restructuring (TDRs), a particularly controversial part of the CECL framework.
Casey’s arguments were threefold. First, that a delay was unnecessary and did not address underlying concerns. In her opinion, apprehensions over the impact of CECL on regulatory capital could be handled directly by regulators, who were already at work on the issue.
Second, Casey maintained that CECL standards provided greater clarity about a bank’s risk portfolio, and as such, was deemed invaluable to investors and a vast improvement over standards in place during the 2008 financial crisis.
Last, Casey addressed McWilliams’ claim that meeting CECL compliance would consume bank resources and attention required to deal with the impacts of the COVID-19 crisis. In her view, since many financial institutions had already communicated expectations to investors regarding upcoming financial results, a delay would “add unnecessary costs for the banks and create confusion for investors.”
Passing of the CARES Act – What it means for CECL Compliance
With the $2 trillion CARES Act came partial relief to banks laboring under CECL compliance challenges, though it is important to note that nothing in the act alters the accounting standard itself.
Instead, the CARES Act includes language exempting all financial institutions from complying with CECL standards until December 31, 2020 or until the President should declare an end to the COVID-19 national crisis. Since that could be tomorrow or a year from now, some argue that the CARES Act should really have no impact on a financial institution’s transition plan.
Financial institutions that were previously subject to the January 2020 deadline will still need to assess the sustainability of their borrowers and collateral. The exemption applies only to regulatory capital, not to publicly reported capital, leverage or earnings. Nearly all SEC filers will still be subject to submitting a first round of public CECL-based financial statements as of March 31, 2020.
For institutions under previously subject to the 2023 CECL deadline, this remains unchanged.
Additional Regulatory Relief and Support
To its credit, the joint agencies2 have enacted unprecedented additional reforms in support of borrowers and lenders. Largest amongst these are new policies and procedures designed to support forgivable loans to borrowers made by banks and guaranteed by the Small Business Administration (SBA) under the CARES Act3. Directed at employees and their employers with less than five hundred people, this new program enables banks to support their small to medium sized enterprise (SME) clients using federal dollars. Implementing this new program is taking Herculean efforts from banks, technology partners and the SBA, but should also help mitigate the COVID-19 credit impact.
The joint agencies have also issued helpful guidance regarding the interaction of CECL reforms from the CARES Act and the new CECL IFR4 which we’ve discussed in part 1 of the market commentary series. Also, the SEC and the FDIC have issued guidance allowing for delays in normal quarterly reporting for the first quarter of 2020.
Implications for Capital, Loan Losses and CECL Compliance
The decisions we, as an industry, make today will have ramifications for decades to come. They will impact our banks, our clients and the people supported by those organizations. Given all the uncertainty, how do we make the best possible judgements around credit adjudication, loan loss calculations and capital management/reporting?
Let’s start by taking stock of what we do know:
- Regardless of your size or filing status, if you are a lender, CECL is on the horizon and here to stay
- Regulatory relief will not impact GAAP reports sent to investors, competitors and clients
- Historic credit data on an event like the COVID-19 pandemic will be essentially nonexistent
- Traditional projection assumptions may be indefensible and will prove inaccurate but will nonetheless be required
- Capital, and in some cases solvency, will hinge on decisions for expected credit loss methodologies and assumptions
Given what we do know, how do we make the best decisions possible? Here are a few ideas:
- Employ multiple loss methodologies. While there is considerable latitude on loss methodologies, the joint agencies and FASB have agreed that five are appropriate for community banks: Vintage, Loss Rate/Roll Rate, Probability of Default x Loss Given Default (PD x LGD), Weighted Average Remaining Maturity (WARM) and Discount Cash Flow (DCF). Each method may be more or less appropriate for specific portfolios, particularly in portfolios where history may not be a good predictor of future results.
- Expand the use of Qualitative Factors or Q-Factors. Long reported to the FDIC by regulated depositories, Q-Factors are manual adjustments to historic data made by management and approved by supervisors. Q-Factors already took on added importance under CECL because of the longer projection period required for loan losses. Under the unprecedented impact of COVID-19, Q-Factors will become critical in converting historical experience to future performance projections.
- Utilize new technology to defend and enhance projections. Right now, nearly 20,000 developers and data scientists are coming together on one platform to tackle the COVID-19 problem. They are generating new data links, relationships and dependencies using new tools at an astonishing rate. They are converting the unknowns to knowns.
Harnessing these new solutions will be critical to the survival of any lender in coming months and years, regardless of size. Explore what’s out there and know the Finastra is driven to bring the unknown into the known for our clients.
1 The FAF overseas FASB
2 Collectively known as the “joint agencies” for purposes of this paper, these are the FDIC, the OCC and the Federal Reserve System (including its member banks)
3 FDIC guidance for implementation of these new SBA loans can be found here https://www.fdic.gov/news/news/financial/2020/fil20033.html?source=govdelivery&utm_medium=email&utm_source=govdelivery
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