CECL Credit Risk
In an effort to help prevent or mitigate another financial bank crisis, in June 2016, the Financial Accounting Standards Board (FASB) issued an update on the measurement of allowances for credit losses. FASB is promoting a shift to “current expected credit loss approach” (CECL). The new approach will now require a threshold to recognize credit losses and will consider the expected loss over the life of the loan. It is expected that all United States SEC filers and other public business entities will be compliant by December 15, 2019 and December 15, 2020, respectively (FASB).
Even if the effective date is still three years away, it is recommended to start the preparation as early as possible. A plan should contain the key dates, duration and units responsible for all activities.
The standard does not prescribe a specific method for the calculation of the expected credit losses. However, it is expected that methodologies should be commensurate with size, nature, complexity and structure of the entity’s exposures (Basel). Therefore, expert judgement should be applied for the following:
- Assessing the level of granularity either individual or collective basis.
- Determining the method for estimation (e.g., discounted cash flow, loss rate, roll rate or probability of default).
- Calculating the expected life of the loan that considers pre-payment.
- Identifying pools with similar risk characteristics (homogenous pools) for collective approach (Basel).
CECL Data Requirements
It is recommended that an entity first assess and maximize the use of its current data and system infrastructure. The data requirements will the following: historical losses, non-accrual status, borrower’s information (e.g., borrower type, DTI, location), loan information (e.g., loan type, effective interest rate), and macro-economic factors (FASB).
After the implementation, the entities should document all the assumptions and judgments made, since this will be the primary source of information for the examiner. Also, there should be proper controls in place to ensure that the calculation of allowances is accurate. Furthermore, an independent unit should regularly validate or review all the processes and models involved (Basel).
To comply with this standard, it is recommended to start now.
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About the Author: Miguel Florez, VP of Credit Risk and Analytics Consulting, leads GDS Link’s Risk Management Consulting and Analytics Group. The group integrates best practices, data and analytics to help companies meet their business objectives.
Sources:
- Basel Committee on Banking Supervision: Guidance on credit risk and accounting for expected credit losses Dec 2015, pg. 8,9,110,124
- FASB, No. 2016-13 June 2016, pg. 4,124
GDS Link offers a tailored CECL solution that will help you to comply with the new reporting requirements.
