By John Voigt
The Financial Accounting Standards Board’s new Current Expected Credit Loss standard brings a significant change to credit loss accounting in the United States, and the road to compliance presents many challenges for financial institutions. While today’s allowance process is commonly operated within a Microsoft Excel-based framework, the additional complexity of the CECL standard will strain this type of approach and make it difficult to maintain the required transparency and controls from quarter to quarter.
With the 2020 deadline nearing, today’s implementation decisions will have major long-term impacts on the efficiency and effectiveness of the new loss allowance process. Financial institutions have a unique opportunity to reinvent their process of projecting loan and lease losses on the balance sheet and maximize its utility as a result.
Creating a defendable and sustainable CECL process requires transparency into all elements and assumptions used in producing the allowance numbers and will be subject to intense scrutiny from a broad group of stakeholders. Each stakeholder will have a unique perspective on what they need from the CECL process:
- Auditors will look for evidence of well-controlled processes and documentation of every assumption that goes into the forecast.
- Regulators will additionally want to understand what other methodologies and assumptions were considered. They will seek evidence that alternatives were assessed and implementation decisions were well informed.
- Investors will seek to understand reported outputs relative to previous periods and in comparison, to peers to assess the market worth of the firm. They often will not have the subject matter expertise to understand the details, so they are looking for clearly explained exhibits and management interpretations of the results.
- Management and the board are ultimately the ones responsible for the integrity of the outputs produced. They will rely on the details provided by their subject-matter experts, and the processes and controls in place, to inform their assessment of the adequacy of the loss allowance.
To create a defendable and sustainable CECL process that can satisfy this diverse audience, there are four key steps all banks need to adhere to: produce clear results; ensure supportable estimates; establish repeatable processes; maintain operational flexibility.
1. Produce clear results.
The ability to summarize the data, understand the drivers of change and communicate a clear and consistent narrative to explain period-to-period changes is essential. Compared to the current allowance methods, there are many more factors that can influence results, and the new standard may produce counterintuitive results at times. As one example, an institution experiencing strong portfolio growth, at a time when its existing portfolio is performing better than expected, could find its allowance requirement increasing simply because the new originations require a larger allowance than the offsetting reduction from the improving portfolio. Imagine explaining to investors that we are increasing loss provisions during a time when we are experiencing better-than-expected credit performance across the portfolio. Producing a clear and well-supported narrative will be imperative.
2. Ensure supportable estimates.
Your process should be designed to provide the information needed for the different challenge processes that are expected by regulators, auditors and managers.
Given that these stakeholders are collectively learning about CECL and its impacts, and the results may seem more volatile and even counterintuitive at times, institutions can expect that the number of questions that they receive will far outnumber the current flow. Internal teams need to be prepared for the influx of requests and ensure their processes provide the ability to retrieve enough detail to respond.
And it is not only important to provide the information the stakeholders seek. It is also beneficial — in terms of perception — that institutions can turn around their responses quickly and answer the inquiries directly. To support this, processes should be established to proactively create supporting exhibits across multiple dimensions and levels of granularity.
3. Establish repeatable processes.
Under today’s accounting rules, the modeling can be fairly simplistic, and many banks have been relying on spreadsheet-based approaches for their allowance estimates. The FASB has been clear that CECL is scalable, and institutions are free to continue using spreadsheets if they choose. However, because of the need for lifetime loss estimation and additional requirements — like vintage disclosures — these types of spreadsheet approaches are going to be strained. At best they will be very slow; at worst they will be unsustainable.
The allowance process cuts across different constituencies that may not have worked this closely in the past. It is important that the institution’s internal teams (credit, finance, accounting) address the aspects of ongoing production up front and begin to reexamine the workflow from the start. This is the time to eliminate manual routines wherever possible and build the necessary control points into the workflow. Establishing automated processes across teams will serve the institution well once the production cycle starts and needs to be regularly performed under tight deadlines.
4. Maintain operational flexibility.
As the standard is largely non-prescriptive, there is no exact blueprint to follow for CECL. It helps to make your process as flexible as possible to allow you to adapt to feedback from regulators or auditors and continue to improve your efficiencies over time.
To support this, the CECL process should provide the ability to dynamically refine your workflows and model components without disrupting the overall process. It should provide parallel testing capabilities to efficiently evaluate impacts of design changes on both the level and future volatility of estimates.
Loss provisioning can drive large swings in the institution’s bottom line and capital position. As a key component of the reported financials, the allowance process is subject to intense scrutiny. CECL has been dubbed the largest change in accounting, and its impacts cannot be understated. Implementation is not easy but, when properly planned, will benefit both financial institutions and the stakeholders it serves.
In addition to meeting the requirements of the standard, strategic investment in CECL implementation can facilitate many strategic activities. It can support business-level analyses, such as the ability to evaluate impacts from strategic moves, such as potential product changes, acquisitions or divestments. It can inform pricing strategies that reflect the true cost of lending. And it can integrate and align with managerial and supervisory stress test processes.
All of this requires upfront planning and design of a highly automated, but flexible, architecture that can adapt to changing requirements over time.
John Voigt is a risk solutions manager at SAS. Contact him at John.Voigt@sas.com.