Pub. 6 2015 Issue 3

fall 2015 29 West Virginia Banker DavidH. Ruffin is amember and co-founder of Credit RiskManagement, L.L.C. which can be found on the web at www.creditriskmgt.com. Randal J. Rabe, CPA is a director at Credit Risk Management, L.L.C. and can be reached at 919-846-1601 or rrabe@creditriskmgt.com. CRM has formed an interest group on Linked-In named CECL. The purpose is to share thoughts, ideas and new information with each other so that we can all effectively prepare for CECL from both a cost and impact perspective. We invite you to join and participate in the group: www.linkd.in/18yYLk4. on non-impaired loans (recognition that you have “probable-in- curred” losses in your non-impaired loans, but that they have not yet been specifically identified). Under CECL, the threshold is not as high as “probable”; in fact, it is a probability that only needs to be greater than zero! And how often do you originate a loan that you have complete certainty that you will receive all interest and principal over the term of the loan? Secondly, the time horizon is different and most likely longer under CECL. Under current methodology, the loss horizon is often estimated at one year although some institutions calculate a loss emergence period that is generally between one and two years. Under CECL, the time horizon is the remaining contrac- tual term of the loan which, on average, is likely to be longer than the bank’s current loss horizon. How much will our ALLL increase when we implement CECL? An analysis performed by the Office of the Comptroller of the Currency (OCC) found that a system-wide increase of 30-50% could be expected. While our overall findings are consistent with the OCC study, we find a wide range within our study, largely dependent on the nature and weighted average maturity of the portfolio as well as the credit quality. Will FASB provide a methodology to calculate CECL? The proposed standard does not provide a prescriptive approach. It does indicate that the estimate must consider the time value of money but that can be accomplished by an explicit approach (such as discounted cash flow) or by various implicit approaches that could include loss-rate methods, roll-rate methods, probabil- ity of default methods or a provision matrix method using loss factors. Significantly, the proposed standard does state that it typically would be inappropriate to estimate the expected credit losses by multiplying an annual loss rate by the remaining years of the asset’s contractual term. It is unlikely that banks will be able to effectively transition current “historical net-charge off ” methods to calculate expected life of loan losses. FASB provides an example of a CECL calculation in the pro- posed standard using vintage analysis; however, considering the various term structures and risk grades within a loan segment, it is difficult to see how a community bank would “operationalize” such an approach. Due primarily to its flexibility, a discounted cash flow model--in- formed by probability of default (PD), loss given default (LGD), and prepayment rates—may become a widely accepted approach to calculate CECL. The key to successfully using this type of model will be determining the appropriate PD’s and LGD’s, both during and after the time period covered by reasonable and supportable forecasts. When will the standard be finalized and when will it become effective? FASB recently indicated that it intends to release the final stan- dard during the fourth quarter of 2015, although it is not clear when the standard would be effective. The International Ac- counting Standards Board (IASB) issued their final impairment standard in mid-2014 with a January 1, 2018 effective date. It is expected that FASB would not set an effective date earlier than January 1, 2018 and it is becoming more likely that it may be January 1, 2019; however, the ALLL impact would be recorded as a cumulative-effect adjustment as of the beginning of the first reporting period in which the guidance is effective. Will the final standard look anything like the proposed standard? FASB has performed extensive outreach and deliberation and has made several tentative decisions during the three-year deliberation process. FASB staffers are currently drafting the final rule and, to date, the main provisions of the proposed standard remain intact. What is the benefit of estimating the CECL im - pact on my bank now? It is likely that the new standard will become effective in January of 2018 or 2019. As banks typically perform capital planning analysis over a 2-3 year period, the end of the planning period bumps right up against the estimated CECL implementation date. In addition, banks that determine their new reserve amount now will have more time to understand the drivers and adjust their portfolio strategies prior to the effective date. What should I be doing today to prepare for CECL? If you only do one thing today, you should obtain as many month-end loan files (flat files or regulatory alert files) as you can access going back as far as you can but certainly try to capture the 2008-2010 financial crisis. Also, obtain loan level charge-off and recovery information over the same look-back period. Put all files in a secure folder and continue to update them going forward. Why? In order to calculate life-of-loan loss estimates, you need a long look-back history. n