It could be argued that CECL (Current Expected Credit Loss) regulation is perhaps the biggest change in accounting standards this century. CECL is a new credit loss standard introduced by the US-based Financial Accounting Standards Board (FASB). It applies to financial assets measured at amortized cost such as held-to-maturity investments and changes the model previously used to measure impairment (the term usually associated with a long-lived asset that has a market which has decreased significantly; an impairment cost must be included under expenses when the book value of an asset exceeds the recoverable amount).
The path to CECL originated in the months leading up to the financial crisis of 2007-2009, when banks did not have sufficient credit loss reserves or capital to absorb the resulting losses. The consequence was additional government intervention to stabilize the financial system. Since then, Congress has devoted attention to strengthening the financial system in an effort to prevent another financial crisis and avoid putting taxpayers at risk.
While the US CECL standards deviate in a few significant ways from the International Financial Reporting Standard (IFRS) 9 published two years earlier, they share an important feature – the calculation of the expected credit loss is now computed over the life of the loan. CECL therefore represents a significant change from the previous incurred loss model (which assumes that all loans will be repaid until evidence to the contrary is identified).
The standard is to be implemented on December 15, 2019 by all banks, savings institutions, credit unions and holding companies. Banks must gather sufficient data to establish a model that determines the estimates of impairment, as well as apply strict processes and controls to ensure compliance. In addition to the requirement to model lifetime expected losses, issues around data quality, availability and collection will likely be at the forefront of implementation efforts.
The problem with the regulation is that the method of measuring the valuations for expected credit loss is not clearly defined. The FASB has given guidance, but it hasn’t been prescriptive about precisely how to perform the valuations; there are many grey areas. The regulator is saying that in terms of credit loss, many different factors can contribute to the calculation of a valuation, based on the type of security, the area of the country, how the position is held and so on. Banks are being asked to perform a calculation without being given all of the variables that contribute to the formula. This ambiguity introduces the concept of bias to an accounting standard.
One aspect of CECL is that it affects two different classifications of securities: securities that are held-to-maturity (HTM) and securities that are available-for-sale (AFS). The way that an organization has to handle these two types of security differs. With an available-for-sale security, firms have to conduct an individual analysis for each security and then account for its credit loss. With a held-to-maturity security, a firm can aggregate these assets to provide, in effect, one pooled loan loss or expected credit loss.
The loss threshold for AFS securities differs from that of HTM. When the intent of an organization is to hold the security for the entire life, the asset’s fair value is not taken into account and therefore there is no lower limit to the amount of loss that could be incurred. Conversely, since an AFS security is measured at fair value, this sets a limit for the amount of impairment that can be taken. This is because there is a potential buyer in the marketplace for the asset, reducing the risk of further losses beyond those reflected in the fair value.
Clients have asked us our intentions from an accounting perspective for Paragon, our fixed income accounting solution. While Paragon does not establish the valuation itself, it does perform the accounting calculation behind it. We therefore explain that we would not be handling the loss calculation, but rather the loss accounting once they had performed their calculations. Some firms are hiring a third party to do those calculations (as they are held in their own Book of Record and that introduces potential bias). The benefit of this approach is that it provides an independent analysis of the securities, reducing the risk of missing a factor that would cause them to miscalculate what the expected credit loss might be on a given security.
Although Accounting teams are typically driving the CECL project and have ultimate ownership, from our experience clients are setting up cross-functional teams including Treasury, Tax, IT and Operations to establish the policies. The Accounting teams will then implement those policies on a day-to-day basis. Clients are certainly putting together large teams that represent a substantial cross-section of their organizations because they are concerned that if they don’t have enough people involved in the initial conversations then they run the risk of missing a key factor. For this reason, many clients are also receiving counsel from third parties such as their audit firms.
In terms of their response to CECL, the biggest difference among the firms we have spoken to is concerned with how their portfolio is structured and whether they anticipate any credit loss. Even with the largest firms, the current trend is to limit the risk by trading in more secured investments, mainly government backed. Much of this is due to capital requirement regulations that dissuaded firms from holding below investment grade bonds in favour of high-quality liquid assets. With portfolios now so plain, many firms feel that a loss is very unlikely. Those firms with more ambitious portfolios tend to be the ones that are creating their CECL taskforce more rapidly.
Efforts to comply with the new credit impairment model is likely to create a downstream impact on an institution’s current business processes, control environment and operating model. Whatever the structure of a bank’s portfolio, with less than a year to the CECL deadline firms must begin to prepare a pathway to the new standard or face heartburn next Christmas.