01 Oct CECL Will Focus on Forward-Looking Forecasts
CECL Will Focus on Forward-Looking Forecasts
By Richard Murphy, Invictus Executive Advisor
One of the most vexing issues to come out of the financial crisis for banks, regulators and accounting boards was the way banks recognize impairments to loans and debt securities. It was painfully apparent that methodologies to estimate losses proved to be highly inadequate, inaccurate and untimely.
By 2012, the Financial Accounting Standard Board’s model for accounting for ALLL, which focused on historical views on “incurred losses,” was deemed unreliable. Losses mushroomed during the crisis years, and delayed recognition of the losses caused pain for banks and investors alike.
In response, FASB in December 2012 issued a number of draft proposals to address the need for more timely recognition of credit impairment and more accurate determination of “estimated” allowance for credit losses. FASB’s draft proposal, “ASU Financial Instruments-Credit Losses – Subtopic 825-15” ushered in an ALLL model based on “current expected credit losses,” better known as CECL. The board is expected to draft the final standard in the first quarter of 2016.
Under the proposed CECL model, a bank would recognize as an allowance its estimate of the contractual cash flows not expected to be collected. Unlike the incurred loss model, the CECL model does not specify a threshold for the recognition of an impairment allowance. Rather, a bank would recognize an impairment allowance equal to the current estimate of expected credit losses for financial assets as of the end of the reporting period. Under CECL, a bank’s expected credit losses represent all contractual cash flows that the bank does not expect to collect over the contractual life of the financial asset.
To make their ALLL estimates under CECL, banks will need to look at the economic conditions at the time of the loan, as well as forward-looking forecasts of what could happen during the life of the loan.
One tool for banks that may become essential is vintage analysis, according to an April 2015 American Bankers Association Discussion paper. It suggested that “vintage analysis, whereby loan portfolios are broken out into cohorts by each issuance year, could become a minimum requirement in order to support the ALLL estimate under CECL.”
Editor’s Note: Richard Murphy, a former FDIC team leader, has spent 30 years in the banking industry.