CECL: introducing another project for banking IT departments

Jeroen Van Doorsselaere, Wolters Kluwer, explains the ins and outs of the new CECL model

There was some big news for bank’s risk and finance technology departments last month. The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.

Notably, this standard introduces a new impairment model, commonly known as the CECL (current expected credit losses) model, which represents a shift from the current incurred loss model. And banks are already exploring the associated technology implementation options. Jeroen Van Doorsselaere, VP of finance and risk at Wolters Kluwer, provides his take on the developments.

CECL is effectively the reaction to the global financial crisis, where the general criticism on accounting standards was “too little too late”. The FASB and the International Accounting Standards Board (IASB) accordingly worked to overhaul the current impairment models.

IASB developed International Financial Reporting Standard (IFRS) 9, as a replacement of IAS39, and FASB has now issued CECL, which adds the US GAAP based countries within the financial sector such as Israel, Japan (limited) and the US itself to the list of countries that needs to apply with forward looking expected losses rather than incurred losses model.

The standard needs to be applied to all entities regulated by the FASB, but there is a phased approach in the application. Given the scope, which will be more closely aligned to financial instruments at amortised costs it would appear the main impact will be on financial institutions or large corporates with a so called “shadow bank”. As a result a multitude of questions are now being asked as banks come to grips with the need to implement the standard.

The deadline for implementation may seem far away, but the work to ensure technology is up to the task must start now. The deadline is for fiscal years starting after December 15, 2019. For public business entities that are not SEC filers, however, the new guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020. For all other organisations, the new guidance is effective for fiscal years beginning after December 15, 2020, and for interim periods within fiscal years beginning after December 15, 2021. An early application is permitted for fiscal years after December 15, 2019.

CECL in a nutshell
This standard will require banks’ accounting models for credit losses to include forward-thinking information that requires a high degree of risk data and judgment. All of these will be subject to management controls, in addition to financial audit. As a result we are bound to see further alignment of banks’ finance and risk function.

The current expected credit loss model regulates the fact that provision will need to be taken against a portfolio of certain asset classes in order to be an effective weapon against expected losses in the future. The new accounting standard, however, will place more emphasis on the expectations and push financial institutions to include more forward looking information on top of the existing historical data set they are using in the current standard. Consequently, the technology to monitor and report such information needs to be overhauled.

Moreover, unlike the current standard, which just recognizes an initial threshold when the contract starts, the current standard will take into account all lifetime expected losses over the whole contractual lifetime of a loan. Other side effects of this standard include more clarifications in the value of assets the moment they are acquired. The value of credit impaired assets will also be comparable to other non- credit impaired assets that are acquired by the financial institutions. Specifically, for FASB users, this will also make it possible to go through an allowance account for available for sale debt instruments rather than using a write off account. IFRS 9 equity investments are not, however, subject to the scope of this expected credit loss.

From a methodological aspect, the FASB, compared to the IASB, pushes forward looking information. Having said this, the moment they cannot be reliably measured they revert to a more backwards looking view, using historical data to fulfil the extrapolation requirements. They also provide some illustrative examples towards this approach about how to solve the forward looking aspect but also some practical expedients towards the application of commitments and over-collateralized loans

It is clear that the use of forward looking information aims to inform investors, but it will be an additional burden for the financial institutions to run this exercise, not least when it comes to implementing the relevant technology.

Adapting to both IFRS 9 and CECL
Financial institutions that are subject to both the IASAB’s IFRS 9 standard and CECL need to be aware that this is not just a “ctrl-R” (i.e. Find and Replace) of IFRS 9. Indeed, there are different nuances set by the two different standard setters. They are also both subject to the guidance published by the Basel Committee for Banking Supervision.

As regards some detailed analysis. The FASB does not apply a three stage model like the IASB but will apply lifetime expected credit losses over the whole portfolio at each moment in time. This means that the difference between individual assessment and collective assessment remains more important under CECL than in the IASB world.

In IFRS 9 the unit of account is brought through a single contract level (also due to stage assessment and those dimensions) while in the context of FASB it seems that collective approaches are more likely to be followed given their illustrative examples. Another difference is that the inclusion of macro-economic factors are stressed on the IASB side while the FASB simply refers to forward looking information leaving it up to interpretations if this includes macro-economic factors or not.

Ultimately, it is now clear that this standard will change how financial statements are read, bringing a huge amount of disclosure and other challenges to the financial sector as a whole. The need to ensure that banks are up to speed with the requirements starts now…