I may be the only one with this opinion, but I don’t think the changes the Financial Accounting Standard Board (FASB) is proposing to how financial institutions account for credit losses will be that big of a deal. Most prognosticators are predicting major disruptions in operations, massive increases in capital requirements, and substantial increases in compliance costs. As I read the proposed update and subsequent clarifications, I just don’t see it.
Will the update require additional data and new procedures? Sure. Will an institution need to transition away from spreadsheets into better ALLL software? Probably. But all in all the update seems to only differ only slightly from current best practices, and if new data and/or software is required it’s probably long overdue anyway and should be able to be used for much more than just estimating credit losses.
Visible Equity works with hundreds of financial institutions of all different sizes and the vast majority are already sending us the required data to effectively account for credit losses. Helping our clients comply with new FASB standards will just be a matter of tweaking our existing ALLL Software to meet the final guidance, which we expect to come in the first half of 2015. Of course sound judgment and defendable assumptions will be required, but this is nothing new. Estimating credit loss has been and will remain largely a subjective exercise.
Beginning in 2009, FASB began a project to incorporate more “forward looking” analysis in accounting for financial instruments and more specifically in accounting for credit losses. Three years later on December 12, 2012, FASB issued an Accounting Standards Update (ASU) that will replace the current “incurred loss model” with an “expected loss model”.
The new model has been named the CECL model (Current Expected Credit Loss), but this is really a misnomer because there is no “one” model that satisfies the requirements in the proposed update.
As of January 2015, FASB is still deliberating and has not issued its final guidelines, but unless they make major last minute changes we have a pretty good idea of what to expect and for most institutions it really boils down to properly segmenting the portfolio, estimating a realistic loss rate (that includes a reasonable forecast), and providing appropriate disclosures.
Properly Segmenting the Portfolio
FASB uses the terms Segment and Class. Visible Equity uses the terms Category, Subcategory, and Grade/Risk Rating in its ALLL Software.
Segment is the level at which an entity develops and documents a systemic methodology to determine its allowance for expected credit losses. Examples of segments include type of debt instrument, the industry sector of the borrower, and risk rate(s). Class is a group of financial assets determined on the basis of measurement attribute, risk characteristics, and an entity’s method for monitoring and assessing credit risk.
Cutting through the jargon of segment and class, you just want your ALLL software to be able to stratify your portfolio to a level that enables you to accurately estimate losses and provide sufficient disclosure. For most institutions the call report level of segmentation coupled with risk ratings/grades is probably about right.
Estimating a Reasonable Loss Rate (that includes a reasonable forecast)
The proposed update requires institutions to consider past events, current conditions, and “reasonable and supportable” forecasts that affect the collectability of cash flows, instead of just past events and current conditions.
All the hand-wringing and consternation surrounding the proposed changes seem to be coming largely from focusing too much on the “forecasting” and “life of loan” concepts introduced by the update. FASB has clarified that an institution does not have to specifically call out the forecast period it is considering, and it should revert to historical loss rates beyond which it can reasonably forecast. Life of loan is taken care of inherently in many models. For example, part of Visible Equity’s ALLL Software uses an unconditional probability of default, which incorporates life of loan estimates. I expect the final guidance will provide more explanation on both of these items.
The forecast can be incorporated by either adjusting the loss rate used or in a supplemental adjustment to a base loss rate. Of course the guidance is short on specifics on the magnitude with which to adjust historic loss rates to reflect changes in current and forecasted conditions, but rightfully so. Remember, judgment is not being abrogated.
Providing Appropriate Disclosures
Disclosures should be made such that users can easily recognize
- The inherent credit risk in the portfolio,
- How management monitors credit quality and estimates expected credit losses, and
- Changes that have taken place in the estimate of credit losses during the applicable period.
While the proposed update will undoubtedly require thoughtful changes in how a portfolio is segmented, the loss rates and forecasting estimates used, and the disclosures made, hopefully the update will turn out to be no big deal after all.