The Financial Accounting Standards Board (FASB) Current Expected Credit Losses (CECL) methodology requires banks and credit unions to evaluate portfolio mix, credit quality and economic forecasts including prepayments, unemployment rates and GDP when assessing credit risk to establish allowances.
Incorporating CECL into systems and data models has proven to be a costly and concerning undertaking. In fact, 84% of small financial institutions responding to the “Tenth Annual Community Bank Survey” conducted by the Risk Management Association reported it as a top concern, along with regulatory compliance since CECL requires earlier reporting of credit losses than incurred-loss modeling.
Challenging economic conditions due to rising interest rates combined with loan concentrations and “lifetime expected loss” calculations could result in higher loss allowances that lower earnings. The ABA expressed concern about this procyclicality – financial stress that could prompt banks to rapidly increase allowances, thereby reducing net income, capital and lending. A revised CECL regulatory transition rule adopted in March 2020 permits the deferment and amortization of initial regulatory capital impact, and the ABA and others have asked regulators to consider how this could become permanent.
Additionally, the ABA noted that community banks have incorporated such factors into their reserve calculations for years, based on historical portfolio performance. CECL presents the challenge of supporting these calculations with economic forecasts. Pointing out community banks’ traditionally close relationships with their borrowers, the ABA questioned how CECL would improve their internal liquidity management when they “must bear the cost of reengineering their credit loss estimation systems and processes for 2023 adoption.”
CECL is not all bad news. According to a Federal Reserve report, it does what it’s intended to do – improve responsiveness of provisioning for credit losses when there are changes in the economic outlook. During the Covid-19 pandemic, CECL adopters’ allowances increased by 76% in the first half of 2020 compared to Q4 2019, while non-adopters’ allowances increased by 32% during the same time period. As the economic outlook began to improve in Q2 2021, adopters’ allowances dropped by 50% while non-adopters’ allowances remained flat, decreasing less than 1%.
Moreover, CECL should lead to higher quality data aggregated in one area, providing better controls and information that can drive strategic priorities. For instance, banks that incorporate CECL metrics into loan pricing go beyond accounting to support effective risk management, too.
As more financial institutions adopted CECL in Q1 2023 reporting, a trend of the impacts may not appear until 2023 financial statements are released in 2024. Contact your Rehmann advisor for an in-depth review of your organization and customized guidance to help manage risk, prepare accurate reporting and remain compliant with CECL standards.