By 2020, financial institutions will have to comply with the Financial Accounting Standards Board’s (FASB) current expected loss standard, otherwise known as CECL.
Instead of recognizing credit losses once incurred, financial institutions will have to calculate the expected loss over the life of each loan and book that loss allowance at the time of origination to meet CECL data requirements.
Accurately predicting loss allowance
In order to accurately predict the loss allowance, banks and credit unions must enact process changes within their institution, as the right approach to CECL will ensure compliance and even position the institution for sustained growth.
These process changes will involve collaboration between various employees, gathering and aggregating data from multiple business lines as well as pooling and segmenting institutions’ loan portfolios.
In other words, your financial institution must piece together its unique puzzle to best calculate loss allowances.
CECL will be a massive change for financial institutions, transforming the way they complete their accounting, not just for loans, but for anything on their balance sheet, including debt securities and leases.
To effectively address and comply with the new standard, your financial institution must take a collaborative approach.
This involves getting employees from several areas, such as accounting, financial modeling, database management, data analytics, credit analysts and more, all on the same page. Each stakeholder from each department can offer their expertise on locating and accessing the right data, which is the foundation of CECL implementation.
Data delivers the insight needed to help financial institutions understand what drives portfolio performance (and how), which is crucial when calculating loss allowance.
Additionally, facilitating cross-team collaboration will ensure transparency and consistency when establishing loss estimation methodologies, as decisions around methods and calculations must be well-supported and clearly governed.
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CECL Results and Reality
As the deadline for CECL implementation approaches, financial institutions should also eliminate silos of data, and—instead— consolidate data so it is more accessible to stakeholders across the institution.
In order to accurately predict the loss allowance, especially for loans with a longer lifecycle, banks and credit unions will need sufficient data, including large amounts of historical data ranging from three to 12-years-old. Other necessary data elements include defaults, attrition and recovery data, collateral information and more. Since data informs how the loan will likely perform, it is crucial that financial institutions capture the right data at origination, understand where the data is stored and identify the data that is still needed.
For some institutions, these data requirements may be challenging to meet and maintain. For instance, banks that have been active in merger and acquisition activities may not have the historical data they need. Or the data may be stored in various systems and in different formats, making it difficult to analyze. For these reasons, financial institutions should start by conducting a gap assessment to determine the availability and quality of data and identify which data elements they lack.
Equals Effective Risk Mitigation
The purpose behind CECL is to help financial institutions better understand how risk will impact a loan from the point of origination through the entire life of the credit. This means that institutions must know which loans are driving profitability versus which ones are hindering profitability. To achieve this, financial institutions should tightly segment their loan portfolios into pools comprised of loans that perform similarly through various economic cycles and scenarios. This requires consistent monitoring of credit quality, which enables the institution to quickly track and identify what influences a portfolio’s performance and which economic factors each portfolio is sensitive to. For example, one bank’s commercial loan portfolio may be extremely sensitive to unemployment rates while another bank’s portfolio is more sensitive to interest rate fluctuations.
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Pricing and Profitability: The Other Side of CECL
Each financial institution has a distinct customer base and therefore, a distinct portfolio makeup, which means every loan portfolio will behave differently. Financial institutions should strive for a deeper understanding of their loan portfolios sooner rather than later so they can gain a more comprehensive view of risk to ultimately mitigate that risk and the earnings volatility that comes with it.
By putting together the puzzle pieces now, financial institutions can reap long-term benefits from CECL. Taking a proactive and collaborative approach to the new standard with profitability and growth in mind will position financial institutions for success well beyond the 2020 deadline.