In the aftermath of the financial crisis, the regulatory and statutory response created a lot of buzz around forward-looking, capital-planning and stress testing for financial institutions and banks. The Financial Accounting Standards Board (FASB) followed suit with the Proposed Accounting Standards Update ASC 825-15, Financial Instruments: Credit Losses, commonly known as the Current Expected Credit Loss model, or CECL.
The FASB’s CECL model is causing angst among financial institutions in the U.S. Most apprehension centers around the proposed lifetime expected loss reserve for all financial instruments measured at amortized cost, and the unknown impact that it will have on the financial statements. Experts estimate that CECL could increase the reserve from 30% to 50%1; our own analysis supports this as a reasonable range.
While the ultimate impact on the financial statements remains unknown today, we do know that CECL will have data implications for financial institutions and will put more stress on those that have not solved fundamental data architecture challenges. The FASB is leaning toward requiring financial institutions to perform a forward-looking analysis of their portfolio. Adapting organizational processes to comply with the new standard will be important for banks. Let’s start at the beginning.
What is CECL?
CECL will require financial institutions to change the way they approach their reserve processes by replacing an incurred loss approach with a lifetime expected loss estimate. This new requirement will have a significant impact on mindset and operations, and most importantly, a financial institution’s reporting and disclosures, which will be more complex than ever. Banks and institutions will need to have a holistic understanding of their reserve and how it will change over time in order to field questions from auditors, investors and regulators.
It is no wonder that banks are waiting with anticipation for the final version of CECL to be issued because the new standard will pose some significant challenges.
First, due to the allowance being a larger component of the financial statements, complex reporting and analytics should be expected. Institutions will need to track their data closely for insight into changes between periods. Documentation and transparency will be critical to support the estimate. For all but the smallest institutions, a manual approach is unlikely to get the job done satisfactorily in the time available during the reporting period.
Second, not only will CECL require banks to understand and incorporate historical loss rates, but they will also need to explicitly include forward-looking assumptions into the calculations. Institutions will have to substantiate the assumptions and their impact on the reserve as it changes over time. This change is profound and signals a departure from the decades-old idea that the allowance should reflect losses that have already been incurred. In the CECL world, changes to forecasts will also change the allowance.
Finally, a comprehensive accounting and credit view will be necessary in order to understand and communicate the method and information used to calculate the reserve as well as the current and projected forecast driving the estimate. Collaboration between accounting and credit can be extremely challenging and risk-ridden when manual steps create the foundation for the processes. We have seen this repeatedly through the years with the allowance under ASC 450 (the former FAS 5). The reserve is under greater scrutiny now, and mistakes in manual processes are amplified to the highest level seen in the past 20 years. Control of process is more important than ever; this explains why a brisk conversion business remains for the reserve from spreadsheets to automated solutions, even though the calculations have changed little, if at all, for most financial institutions.
These anticipated challenges overshadow the debate around CECL, and many financial institutions have grown to dread the final standard. Some institutions have buried their heads in the sand while they await the decision rather than proactively preparing. This is the wrong approach. There is no need to fear because there is a right way to handle new accounting standards and regulatory changes.
Preparing for CECL
The post-crisis environment has been one of rapid change — more loans subject to complex accounting standards, greater disclosures, heightened regulatory expectation (and in some cases new interpretations). The result has been many inefficient, manual and hard-to-control processes by banks that assume the only option available to them is another spreadsheet and point of reconciliation.
For banks that continue to operate with siloed departments, CECL will be the proverbial straw that breaks the camel’s back. For all but the smallest institutions, it will be imperative to integrate the accounting and credit departments with an automated solution that provides one source of truth: the most accurate and up-to-date information stored in one location. CECL will not be a significant process issue for banks that approach the challenge using a platform solution with an integrated data architecture.
Implementing a Platform
Banks will benefit greatly from streamlining their processes and finding a solution to connect all sources of data for an all-inclusive view of risk and accounting. Consider your credit monitoring process; is it automated or does it require hand-offs and reconciliations between different groups? A software-as-a-solution (SaaS) platform with an open architecture allows financial institutions to bring in data from the servicing system, risk systems, spreadsheets — wherever data is stored — to easily perform required calculations, and update and automate reporting.
Today’s accounting platforms are based on FASB requirements and are architected to be broad, flexible and adaptable. They support current business needs, as well as future developments, and are designed so new functionality can be built on top of them, leveraging core components. This means the business requirements can be updated quickly. When accounting rules change, the platform can be leveraged without building a new system from the ground up. Combined with a SaaS delivery model, properly designed platforms can adapt as fast as the changing business and regulatory landscape. SaaS applications are not installed on site. Rather, they are licensed and centrally managed by the software provider. As a result, upgrades are performed by the service provider quickly and seamlessly without interruption of day-to-day processes.
Today’s platforms have powerful features, and the latest generation takes it to another level. Real platforms — with domain-specific data models, well-architected integration components and modern delivery models — can fundamentally improve the way an institution performs key functions.
While we do not know what the ultimate implications of the CECL model will be, history tends to repeat itself. CECL provides banks with an opportunity to learn from the mistakes of the past. Financial institutions that close the technology gap and replace their manual processes with automated solutions will pave the way to adapt rapidly to change and perform operations better, faster and cheaper than ever before.
Lauren Smith is a CPA licensed in Virginia, and senior manager, and John Lankenau is the head of valuation and accounting product solutions, both at Primatics Financial.
1. Source: http://www.occ.gov/news-issuances/speeches/2013/pub-speech-2013-136.pdf↩