Professionals Around a Computer

Banks and credit unions should understand the Financial Accounting Standards Board’s proposed changes to the standard for calculating the allowance for loan and lease loss.

What Financial Institutions Need to Know About FASB’s Proposed Model for Credit Losses

  • Todd Sprang
  • 6/3/2013

What Financial Institutions Need to Know About FASB’s Proposed Model for Credit Losses

In December 2012, the Financial Accounting Standards Board (FASB) issued a proposal to create a new model for calculating the allowance for loan and lease loss (ALLL) at financial institutions. For most institutions, this will impact the impairment calculations for their loan portfolio, loan commitments, and investment portfolio. Although it may take awhile for a new model to be finalized, banks and credit unions should understand how the proposed model may affect them.

Why is a new model proposed?

During the recent financial crisis, the current loss model used by institutions (the incurred loss model) only recognized losses that were probable, even higher loan losses were imminent in the future. The proposed model, current expected credit loss (CECL), was created to address this weakness and provide investors with information about a financial institution’s best estimate of current and future loans within their portfolio.

How does it work?

Utilizing the CECL model, a financial institution will estimate the value of all future cash flows it doesn’t expect to collect on its loans and discount those cash flows to the present time, using the loan’s effective rate as the discount rate. This estimate of cash flows will be based on a combination of quantitative and qualitative information currently utilized, such as historical loss experience, past events, and current underwriting standards.

The model will also add additional considerations, such as forecasts of expected losses based on an estimate of the current point on the loan’s life cycle in relation to the current economic cycle.

We believe that estimating the timing and extent of these future losses will pose a significant challenge to financial institutions’ management teams.

Will this increase the ALLL?

Most financial institutions expect allowance levels to increase because most current incurred loss calculations are sufficient to cover losses over the next twelve months. Because the CECL model estimates losses over the life of the loan, the ALLL levels under this model may be two to three times that of the current incurred loss model.

However, the direction and extent of CECL model results will depend heavily on the timing and extent of future losses. Therefore, ALLL levels under the CECL model may not be as high as expected, and may even be lower than current levels if future economic conditions are expected to result in lower expected losses.

When will the new model be implemented?

The proposal doesn’t include an expected effective date. Based on the volume of detailed data needed and the complexity of the CECL model, it could take two or three years for an institution to have the information necessary to properly calculate its ALLL under a CECL model.

Also, based on the amount of time it took institutions and regulators to properly implement the 2006 interagency guidance on the ALLL, it could take another two or three years before institutions are truly comfortable with the CECL model process.

Should I prepare for these changes?

We advise that institutions use a “wait and see” approach, but educate themselves in the meantime on the issues being debated. The comment process on the exposure draft ended on May 31, 2013, and many parties have strong feelings on this subject. Also, the International Accounting Standards Board (IASB) proposed a model for calculating ALLL that differs from the CECL model proposed by FASB, so it is unclear what the final standard will be.

Furthermore, the current modeling methodology needs to continue to remain compliant with the incurred loss model to comply with Generally Accepted Accounting Standards. Financial institutions should therefore not incorporate expected losses into their current qualitative factors.

How we can help

Financial institutions will be deeply affected by this major overhaul, when it is implemented. Contact your engagement partner for more information on how the proposed standards may affect your company.