Following the turmoil triggered by the global financial crisis, financial regulators raised concerns about credit reserve practices and reporting under prevailing Generally Accepted Accounting Practices (GAAP) rules. The legacy “incurred loss” standards required reporting of losses only once it became probable that a credit event resulting in a loss had already occurred. This limited firms’ ability to set aside reserves for expected losses ahead of time. During the financial crisis, firms were unable to recognize losses that were likely to occur in the near future but had not yet breached the “probable” threshold. In the U.S., the Financial Accounting Standards Board (FASB) addressed this shortcoming by issuing the Current Expected Credit Loss (CECL) [1] standards in 2016. CECL requires firms to maintain reserves for expected lifetime losses upon the origination (or purchase) of credit exposures such as loans, leases, trade receivables and debt securities. Although financial institutions may be most impacted by CECL rules, the requirements apply to all firms that adhere to GAAP standards.
Figure 1: Loan Lifecycle - CECL vs. Incurred Loss
While large, public firms known as “SEC-Filing Public Business Entities” (PBEs) have already adopted CECL standards for fiscal years following December 15, 2019, adherence remains challenging for smaller firms. Advocates for small banks and credit unions have argued that CECL standards will cause lending activities to dry up during economic downturns, further curtailing lending activities during challenging times. In November 2019, FASB delayed implementation of the new rule for non-PBEs until 2022, providing additional time to study the impact of CECL standards at larger firms. A preliminary Treasury Department study ordered by Congress in 2020 did not yield conclusive answers mainly due to the significant market disruptions caused by the COVID-19 pandemic.
Figure 2 - CECL Implementation Timeline
Navigating a changing future
Regardless of the precise timeline, industry-wide CECL adoption remains a complex endeavor. The new reserve requirements pivot loan loss predictions by 180 degrees, from backwards looking to forward. Firms will need to transition from historical credit data to predict probable losses, to incorporating both historical loss data and economic forecasts. Furthermore, the new guidelines are “principles-based” and do not provide methodologies on exactly how forward-looking projections should be employed. This will require many firms to develop forward looking loss models and at the same time integrate those models into their existing reserve frameworks. Finally, significant documentation of models, data, and controls is required to support the loan loss reserves calculations. The stakes are high, as these changes have significant impacts on the pricing and profitability of credit instruments and represent an organization-wide effort to adopt. The transition will require new or revamped data collection processes and storage systems, forecasting and modelling systems, data validation processes, governance controls and end-to-end changes to accounting and reporting processes.
Taking advantage of additional time to prepare
Given the high stakes and the technical complexities outlined above, smaller companies will likely benefit from the two additional years to complete the transition to CECL standards. For firms that have not yet started this work, the delay provides additional time to plan a successful transition. Firms that are already on their CECL journey should examine the lessons learned by larger institutions to finetune their approaches and implementation plans. Revisiting assumptions and ensuring that plans are fully updated can help smooth the remaining path to implementation.
Regardless of the state of their current CECL implementation efforts, all firms that are in-scope for the remaining phases of CECL should ensure that they are taking full advantage of the additional two years to implement CECL in a way that minimizes technical debt and reduces operational, modelling and compliance risk during future audits or regulatory examinations. Firms with limited expertise in large-scale transitions should seek outside help to ensure their efforts remain on-track. Implementing strong governance structures, identifying gaps in data collection, testing systems and validating models are all areas of high importance that can be tackled systematically with additional time and expertise.
About Monticello
Monticello consultants have extensive experience in the implementation of large-scale regulatory initiatives. Our firm understands the importance of diligent analysis, program management, and collaboration across teams within major financial institutions and across the industry. Our current work on LIBOR Transition, Uncleared Margin Rules (UMR), Qualified Financial Contract (QFC) Record Keeping and US Stay regulations demonstrates the important regulatory expertise our consultants bring to our clients. Our teams possess deep knowledge of capital markets instruments, legal agreements and operational processes, as well as the related data and information systems impacts that will be in focus for the migration to CECL. Monticello teams are dynamic, flexible, and highly motivated to assist you in your transition.
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