CECL: Look Beyond the Doom and Gloom Headlines

Financial institution news articles are full of ominous warnings and worrisome predictions about CECL – the new Current Expected Credit Loss accounting and loan loss standard. We’d like to add our perspective to the debate. Let’s start with those doomsday predictions about the size of CECL reserves dwarfing those of the existing as-incurred methodology. That’s simply not true. The fact is that total CECL losses will be exactly the same total size as losses under the as-incurred method. What’s going to differ is the timing of those losses.

Up until now your regulators and accountants wouldn’t allow you to set aside reserves until a significant negative credit event happened.  They were too busy worrying about bankers “padding the books” with extra loss reserves. Now, with the events of the mid-2000s credit crisis squarely focused in their rearview mirrors, the examiner/CPA community is going to require us to book estimated historical loss rates at the same time we book new loans. That’s where the timing difference comes in.

So what’s the bottom line?  Longer term loans will require larger credit reserves to be established on the front end.  This will reduce the ROE on longer term loans and make them even less attractive to community banks. Expect your examiners to take this a step further and insist you build your CECL loss estimates into both your loan pricing and your capital planning.

Next let’s look at complexity.  Many pundits bemoan how woefully unprepared most community banks are to handle the intensive data management and complex modeling requirements of CECL.  It’s a really interesting perspective, but it too is simply wrong. Our regulators have gone out of their way to reassure banks that CECL will be applied in a fashion consistent with the size and complexity of the institution. In fact they have told banks that if you are not doing complicated loan-by-loan analysis now they won’t expect you to do it with CECL either. Nor will they require community banks to master complex statistical or probabilistic modeling.

Now, as we all know, sometimes the reasonable message coming out of Washington DC is distorted once the field examiners get their feet wet with new techniques and requirements.  We saw it with stress testing and we will likely see it again with CECL. Until regulators get a few CECL exam cycles under their belt we expect simpler aggregate methods to be fully acceptable. Later, we’ll see spotty evidence of complexity creep as examiners start to demand more from even the smallest, least complex banks. But the good news is that’s likely 5 years or more in the future. Here’s the bottom line… Make your CECL data gathering and calculation process scalable so it can grow with you. Rest easy with an aggregate process to start but be ready for loan level analysis in the future. That gives you plenty of time to identify and gather data for tomorrow’s more involved methodologies.

Finally let’s address the implementation of CECL. There’s lots of hand-wringing over the unknowns associated with a delayed implementation timeline. What if the economy stumbles? What if credit losses spike? It’s simply human nature to have a healthy respect for the unknown. And with 2 years of remaining implementation runway for many banks, it’s good to consider what can go wrong.

But our view focuses more on the things we can do today, not the things that might happen in the future. For example, have you modeled your bank’s exposure to CECL? How will your reserves change?  We can help you model it now using today’s data. And for all the worries over what could happen, most banks we examine find CECL offering a fairly smooth transition. Some banks even find an immediate reduction in required reserves. If you think about it, the past few years (representing the most recent loss experience) have represented a fairly benign credit loss environment. So it’s not really surprising to see that CECL, far from being something to be feared, can actually be a fairly smooth changeover.

In summary, make sure you pay attention to CECL. It’s the most important change to loan loss reserves in years. Just don’t let some Chicken Littles in the banking media and a few unknown data points keep you from approaching CECL with a clear view of the opportunities and strategies needed to profit from it.

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