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CECL’s on its way

Community banks gearing up for major accounting movement

"CECL is an effort in futility that won't help banks, regulators, or consumers," says Tennessee banker McCall Wilson. "CECL is an effort in futility that won't help banks, regulators, or consumers," says Tennessee banker McCall Wilson.

CECL is coming! CECL is coming! Will community banks be ready on time?

The short answer: Yes. But smaller banks are divided on whether or not the time-consuming transition to the new accounting standard will provide useful information for all the work needed to prepare and comply.

The new accounting standard for “current expected credit losses,” or CECL, was adopted by the Financial Accounting Standards Board (FASB) in June 2016. The new rules are intended to address concerns raised by a wide range of stakeholders following the 2008 financial crisis. The effective date for CECL implementation is 2020 for SEC-registered banks and 2021 for others.

Under CECL, financial institutions will be required to include reasonable and supportable forecasts in a forward-looking credit loss estimate, rather than relying on past events and current conditions. Prior to CECL, banks could only report losses when they occurred. CECL will entail cross-functional changes to the end-to-end reserving process for financial assets measured at amortized cost.

Catching CECL train

Bankers interviewed by Banking Exchange are confident they can meet the implementation deadline, but they disagree about whether or not the new standard will improve risk management or loan forecasting. Views differ among bankers and their industry associations concerning the impact CECL will have on institutions.

James Kendrick, first vice-president of accounting and capital policy at the Independent Community Bankers Association (ICBA), says CECL’s impact on community banks will be minimal. “Community banks are using a forward-looking approach now because the regulators require it,” he says. “The successful transition to the new standard is not an issue at this point because they can use existing processes. If they are using narratives or existing spreadsheets, they can continue doing that.”

Mark Zmiewski, director of enterprise risk and product management at the Risk Management Association (RMA) agrees.

“Practices and policies are already in place to produce and govern the ALLL,” he says, referring to Allowance for Loan and Lease Losses. “The underpinnings—or inputs—are changing, which will require a different way of thinking about estimating losses. For example, the starting point for recognition is moving up, but the fundamental concept of reasonably predicting the future state of the portfolio is very similar.”

In terms of banks’ readiness to implement CECL, Zmiewski says there are several pre-adoption stages: awareness, preparation, and implementation. “Most banks are aware and many are scoping out the resources they will need,” he says. “Implementation is still a ways off, especially since it does not go into effect until year-end 2019 for early adoption. We expect that preparation will pick up considerable speed in 2017.”

Banking associations are helping members prepare. RMA developed a Community Bank CECL Service to capture, store, and report on loan loss information. It provides a framework for data that can be leveraged for use with the ALLL, risk ratings, concentrations, and limits, and provides insight into deal structures. The American Bankers Association and ICBA offer webinars, videos, and workshops. A future ICBA webinar will focus on regulator implementation and scrutiny.

Mike Gullette, ABA vice-president of accounting and financial management, says most community banks are in the early planning stages, if they have started. “Right now, we’re trying to get them to focus on what kind of data they need to start collecting.”

It is rare for any bank to track and maintain any credit-related information on a lifetime basis, according to Gullette. He points out:

• Origination dates are rarely maintained more than three years.

• Charge-off rates are normally based on annual data, not lifetime, even for large banks. That must change. For example, banks normally track classified loan loss percentages only over the next year. It’s the same for delinquencies. Even large banks that have probabilities of default compute them over one year, not a lifetime. Formulating the percentages on a lifetime basis is very data intensive.

• Key underwriting drivers like FICO have never been analyzed over a lifetime at most institutions.

• Banks will need to collect data to give a basis regarding how their forecast assumptions will impact future charge-offs over a lifetime.

Gullette says it won’t be difficult for banks to meet the deadline or get past the first audit. He believes banks may run into difficulties after the second or third audits, when credit conditions have changed. That’s why he believes that banks won’t know if their transitions to CECL are successful by the implementation date. “This is about how banks will manage capital and view credit risk,” he says. Success will be demonstrated when a bank can back up why its allowance should be 50 or 100 basis points higher.

Investor benefits?

When asked if CECL will provide more useful information to stakeholders, Gullette and Zmiewski say, “It depends.”

Gullette says new disclosures about the loan portfolio may result in new questions: “It’s opening up a black box, and now, all of a sudden, people will see what you are doing about this or doing about that. Transparency is a good thing.”

Zmiewski says the bank’s accountants and regulators have always had an in-depth look into banks’ books, and CECL will not provide them with more information. But investors may find better quality information disclosed in financial statement footnotes. “In this sense,” he says, “there is an opportunity for banks to tell a good story about their risk management capabilities and how they have translated it into performance.”

Portfolio ups, downs

Ideally, ALLL isn’t just about keeping auditors, regulators, and investors happy, but about running the bank well. Portfolio volatility could impact a bank’s credit loss forecast, and many banks are not sure whether or not the CECL analysis will provide a better fix on what their risk is, explains Gullette. Institutions are concerned about explaining volatility to the aforementioned parties.

Zmiewski isn’t as concerned. “The biggest change will obviously come at the point of transition in either 2019 or 2020,” he says. “By all forecasts, ‘the number’ will be bigger. Perhaps for a few quarters after that there may be some movement as the process evolves and refinements are made, but in terms of random volatility, I don’t think there will be much. Unless your bank has radically changed its risk appetite—and thus its risk profile—or has grown significantly through introducing new products or expanding into new markets, for example, the relative stability of the customer base should keep things within a reasonable band.”

Starting with CECL

Chad Kellar, partner, Crowe Horwath Advisory Services, says most banks are in the education stage of CECL preparation, participating in conferences and webinars, talking to service providers, and considering software packages. His organization offers transition guidance, illustrating how methodologies may change using bank practices today.

Kellar emphasizes that banks should start the process early, performing assessments and collecting data. “CECL is a change in perspective in how you look at the allowance, and so it requires different data points and methodologies.” Yes, there is flexibility in the standard, but “scalability is in the eye of the beholder,” he says. As with all regulatory and accounting changes, it will require time and effort.

CECL provides some benefits. As part of an overall business strategy, CECL pulls credit losses forward, which impacts capital planning and budgeting. It helps organizations view the business holistically. The disclosures that appear in financial statement footnotes will be useful to the marketplace, particularly during a bank merger or acquisition.

Kellar recommends that banks begin assembling information for the transition now, so they can run the models for 12 to 18 months before the effective date. “That’s a best practice for any model implementation,” he says. “It will give you four to six quarterly observations on how the model will react in that environment.” Kellar says the models should reflect market dynamics, but notes: “Banks need to be careful about the volatility assumptions built into their models. The current credit environment is fairly stable, but those assumptions may not be as relevant in the future, as the magnitude of that volatility could be significantly different when CECL is fully implemented in the future.”

Some of Kellar’s clients are exploring using outside technical help. He advises them to take control of the process and look at various types of data that can be collected and utilized. “Our own process starts with risk identification and then drilling down to see what kind of models may be needed,” he says. “Next is assembling teams and getting a collaborative view of where the risk is and then incorporating data into methodologies.”

BANKS GETTING READY

There isn’t unanimity on CECL implementation among the community bankers interviewed by Banking Exchange. Most aren’t sure if the new standard’s requirements will impact their performance; a few believe that the change is part of their enterprise risk management journey.

Powell Valley Bankshares, Inc.

Leton Harding, CEO of this $270 million-assets bank in Jonesville, Va., says his bank began preparing for CECL before the standard was finalized in June. It began to question RMA, ABA, and its CPA firm about how best to prepare. The bank also made CECL a discussion item with its outside vendor in August during its core software IT transfer to a service bureau.

Internally, the bank’s asset liability management committee, which also serves as its risk management committee, considered what would be needed to comply. Powell Valley is currently evaluating a new loan platform system that will help gather information for CECL as well as contribute to its general risk management. The focus will be on the data points and information needed for input into the core system for current and future loan trend assessments.

Harding believes that banks in rural markets like his are unique—not only from larger institutions, which don’t operate there, but from rural banks in other parts of the country, which may have a client base more dependent on specific industries, such as cattle, energy production and natural resource development, or tourism. He says regulators should provide guidance specifically for rural banks because they face challenges in collateral and portfolio diversification.

“Much of the land here in our county doesn’t have municipal-developed water and sewer; some land may have timber; some properties are multiuse, combining, for example, farming, cattle production, or retail,” says Harding. “Customers’ incomes are generally low-to-moderate or unstable; some customers are self-employed.”

While Harding believes CECL will cause banks to analyze the data they measure, he doesn’t expect it will cause his bank to change its “fairly conservative” practices on loan policy and loan loss reserves. But he believes the potential for information and measurement will be improved in as much as its loan system’s robustness will improve via CECL.

Harding is providing staff members with information about CECL and asking them to participate in training. “There may be some point where we have to work on pricing structures, but that’s yet to come,” he says. “We’re doing assessments on the front end. We might have to document somewhat differently, but the process shouldn’t change much if you’re already practicing good risk management.”

Bank of Fayette County

McCall Wilson, president and CEO of the $460 million-assets bank in Moscow, Tenn., says his bank has started preparing for CECL, but is “nowhere near where we need to be.” No fan of CECL, Wilson calls it “an effort in futility” that will not help the bank, the regulators, or the consumers to whom the compliance costs will have to be passed.

Wilson’s bank got through the Great Recession using only $1.2 million of its $4.5 million in reserves. “The current system has served us well, and our bankers understand the exposure that’s in our portfolios,” he explains. But Wilson says his bank will modify its system to fit CECL requirements, which will require manual reports and add to the workload of an employee in operations or accounting. If necessary, the bank would consider hiring another person.

Lewis & Clark Bank

Trey Maust, copresident and CEO, says this $170 million-assets bank in Portland, Ore., has been capturing data points needed for CECL in a model it created six or seven years ago. Because the bank has a high concentration in CRE loans, it needs a more sophisticated model than what a bank its size would typically employ.

“We’re missing just a couple of the pieces for CECL,” Maust says, noting the bank needs to do migration analysis to identify probability of default for loans through their life cycle. “When CECL was first proposed, we had already been thinking the methodology we are using today aligns with the requirements. It was commensurate with the concentration of risk in our portfolio. It supported the loan loss allowance levels that we were holding on the books. My concern with the implementation process is that ALLL will rise significantly across the industry.”

Maust worries regulators will assume something is wrong with a bank’s model if it indicates a bank does not need to increase its allowance as much as its peers.

Maust expects the transition to CECL to be incremental. He is concerned about its impact on capital and staff workload. He believes additional disclosures that appear in footnotes will be useful to investors, and the new standard creates the potential for the balance sheet to be a more accurate representation of discounted cash flow in the loan portfolio.

First Bethany Bank & Trust

Jane Haskin, president and CEO of this $196 million-assets Oklahoma bank, believes the model her bank uses for loan loss calculation is similar to what it will need for the new accounting standard. “As a small community bank, I was relieved that the document specifically says the complexity of the calculation needs to reflect the complexity of the bank,” she says. “Community banks don’t have the same risk profile as larger banks. The loans we make are not as complicated.”

The bank is discussing CECL implementation with its board and is providing a review of what it may entail. It is identifying how current practices may be used in the new system; reviewing how its current system for loan loss calculation can be leveraged for use with the new standard; and analyzing CECL’s effect on capital. The bank has realized it will not have to do a great deal of new modeling for its calculations. “We pretty much have a lot of compliance in place,” Haskin says.

The First National Bank of Elmer

Brian Jones, CEO of this $244 million-assets New Jersey bank, expected to be CECL compliant by year-end 2016, thanks to its engagement of a third-party vendor to perform ALLL, stress testing, and portfolio and concentration management.

Jones believes CECL accounting will provide more useful information than accounting for expected loss (EL). He says the bank will run EL and CECL for a period of time to evaluate the differences before fully integrating the new standard. “Nobody really knows the impact CECL will have on loan loss reserves,” he says. “Some people think it would require as much as 30% more in loan loss reserves.”

Jones says CECL requires banks to have a more holistic understanding of reserves and forward-looking assumptions. “You have to understand what you’re doing to the nth level. It’s a more complicated model that requires you to build a system or use a vendor.” He hopes regulators will give banks time to adjust even after the effective date.

First Community Bank and Trust

As one of three bankers representing ICBA at the FASB board meeting, Greg Ohlendorf, CEO of this $150 million-assets bank in Beecher, Ill., spent two months preparing for the meeting and four to five months working with FASB on the document that was released.

“Community banks absolutely will not need to purchase a model,” he says. “That was clear out of FASB. The regulators know the community banks have a variety of techniques to develop their forecasts.”

Ohlendorf advises small banks to understand how their portfolios will perform in the future in terms of the economy and competition in their markets. “Reviewing qualitative risk factors will take us a long way down the road toward CECL compliance,” he says.

While it’s too early to know if the bank will continue to use its current loss estimation for CECL, Ohlendorf says, “it will be interesting to see what sources of information the regulators will want to see. They’re giving us plenty of time to test models prior to implementation.”

Ohlendorf has met with the president and staff of the Federal Reserve Bank of Chicago and with field examiners to share their understanding of what will be required to comply with CECL and to provide the bank’s thoughts regarding compliance. “It’s important that every bank engage in open dialogue with other key stakeholders. The sooner they start having those conversations, the better off we’ll all be,” he says.

Ohlendorf does not complain about the workload CECL compliance represents. “There’s always work that has to be done to comply with the changing regulatory and accounting landscape, but that’s our business,” he says. “Not a year goes by that we don’t have to implement changes. This one is not insurmountable.”

Kathie Beans

Kathie Beans is an award-winning journalist and editor with 20 years of experience in the financial services industry. She was the editor of The RMA Journal during the financial crisis until 2014. She writes for banking and insurance industry publications about risk management issues as well as regulatory and accounting developments.

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