A Practical Guide for CECL Implementation in Community Banks
By now, most community bankers are familiar with the theoretical concepts of the current expected credit loss standard (CECL). However, you may have met with a professional or attended a webinar, then headed back to your bank and struggled with applying the theoretical concepts you just learned. That’s why we put together a few simple steps to help you start your implementation process.
Form an implementation team
CECL implementation cannot be the responsibility of just one or two people. It requires a team that should include:
- A chief financial officer or equivalent who has knowledge of loan loss accounting and basic modeling capabilities
- A chief audit executive or equivalent to identify key controls necessary to the new process
- A chief credit officer with deep knowledge of the loan portfolio and related documentation
- A chief technology officer to assist with data gathering and retention
We recommend documenting the members of your team and briefly summarizing each person’s skill sets and roles.
Confirm your implementation deadline
Generally, your deadline for implementation is based on whether or not you are considered a public business entity (PBE), unless you are an SEC registrant. It is important to periodically re-evaluate, document, and receive concurrence from auditors and/or regulators regarding your PBE conclusion. The American Institute of Certified Public Accountants (AICPA) has published a technical questions and answers document that can help you with this determination. Based on this document, most non-SEC registrants will not qualify as a PBE. This results in the implementation deadline for most institutions being December 31, 2021.
Establish a simple project plan
A CECL project plan does not need to be voluminous to be effective. Start with a single page implementation timeline as a foundation. Next, break the project into manageable segments.
For near-term segments, record specific tasks and dates, assigning broader timeframes to the latter segments to allow sufficient time in the event that you experience changes in your operations, such as an acquisition or PBE classification updates.
CECL’s impact versus industry expectations
It’s difficult to know how CECL will impact your organization without first understanding industry reserve levels compared to current accounting rules. For the historical loss component of the allowance, which will be the base component for this new standard, current industry data shows the following:
- Most financial institutions use between a three- and five-year average annual loss rate to compute the historical loss component of the allowance.
- Based on quarterly call report data, the average three-year net charge-off rate for all bank loans from December 31, 2015, to December 31, 2017, is 0.50 percent. The average five-year net charge-off rate is 0.53 percent.
- The ratio of allowance to loans for the historical loss component for all banks with more than $1 billion in assets is 1.24 percent as of March 31, 2018.
Under current accounting rules, this data would suggest the industry believes incurred losses in the loan portfolio are 0.71 percent to 0.74 percent worse than the average of the last three to five years of actual charge-offs. This could indicate there may be some excess in current reserve levels, which could reduce your previous expectation of the impact CECL will have on your institution.
Determine data warehousing
Depending on which methodology you select, the amount of data you’ll need to gather can vary greatly. Therefore, community banks may need to explore other alternatives to warehousing the data beyond Excel. If an institution is going to use Excel as its warehouse, steps will need to be taken to verify that data and formulas are properly controlled to prevent errors in the calculation. This will require more diligence than currently employed for the allowance for loan loss calculations and may prove to be a cumbersome process. Most significantly, some banks may find that they cannot manage this task internally. Starting implementation as soon as feasibly possible can help determine whether your bank has the skills in-house to manage its data, or if you will need to outsource this function. Another important step in data retention is to ensure core system reports are maintained for a period of time. That way, you will have the data necessary to start building your model(s).
In our modeling efforts, we began by considering what models can be built with information that is likely readily available to most community banks (i.e., a standard loan trial balance, history of net charge-offs by loan number, and a watch list for several periods of time). Starting with a limited number of data points and simple models helps banks gain familiarity with modeling basics and identify modeling flaws and potential additional data point requirements. We were pleasantly surprised to discover that effective models, such as remaining maturity analysis, vintage analysis, migration analysis, and static pool analysis, can start to be built with these limited data points.
Categorization of acquired loans
Under current accounting standards, acquired loans are broken out between purchased credit-impaired (PCI) loans or purchased performing loans. For a loan to be considered PCI, it had to be probable that the bank was not going to collect payments in accordance with contractual terms. This is a high threshold to meet, so most loans fall into the purchased performing category; loans are then recorded at fair value on day one, and no allowance for loan loss is recorded against these loans on the date of acquisition. The accounting for PCI loans can be cumbersome for community banks, as expected cash flows have to be established, and income accretion is recorded based on these expectations. A nonaccretable discount was created to absorb future charge-offs, and additional allowance for loan loss was only recorded if further impairment was recognized.
Under the new accounting standard, loans will be divided into purchased credit deteriorated (PCD) loans and non-PCD loans. For a loan to be considered PCD, it has to have experienced a more-than-insignificant deterioration of credit quality. Based on this definition, more loans will fall into the PCD category than the previously defined PCI category under current accounting standards. However, the accounting for these loans is much simpler — instead of the fair value adjustment being recorded as a discount against the loan balance, as it is today, the portion of the discount related to credit adjustments is recorded to the allowance for loan loss. Unlike today’s process, no cash flow analysis or nonaccretable discount is required to determine income accretion.
For non-PCD loans, discounts required to adjust the loans to fair value cannot be used to support credit loss on day one as they are today. For loans that meet this classification, allowance for loan loss will need to be recorded upon acquisition, with the offsetting entry being recorded to loan loss provision.
The following shows example journal entries comparing PCI versus PCD loans, and purchased performing loans versus non-PCD loans to help you understand the impact of these designations:
Assumption: acquired one problem loan with a book value of $100,000. Expected cash flow is $80,000, fair value of the loan is $70,000. Acquired one performing loan with a book value of $100,000. Fair value is $95,000, with the portion of the discount related to credit adjustments being $2,000. The journal entries would be as follows:
Watch for additional updates
Community banks should continue to monitor developments and updates to this standard as it progresses. Various industry expert panels are meeting on an ongoing basis to discuss potential issues and clarify positions related to this standard. It should be noted that institutions that have started the implementation process have been an integral part of identifying known issues, which are being compiled by the AICPA; therefore, it is prudent for community banks to begin implementation in order to assist in this process.
How we can help
CliftonLarsonAllen’s (CLA) professionals are well-versed in community banks and are helping institutions convert the theoretical concepts of CECL into action and progress. To help guide you through the new standard, we have prepared tools to help you with implementation and will continue to stay on the lookout for updates to help keep you informed.