1. Preparing for CECL: the Current Expected Credit Loss Model
2016 Connecticut Directors College
Preparing for CECL: the Current Expected Credit Loss Model
December 8, 2016

2. Current Expected Credit Loss Model
ASU , “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” issued during June of 2016.
Today’s Agenda:
Why CECL?
CECL vs. Incurred Loss Model
Terminology
Disclosures
Available-for-Sale Debt Securities
Recommendations during the Implementation Phase
Questions?

3. Why CECL?

4. Purpose of CECL
FASB wished to address weaknesses identified in current practice following the recent global economic crisis by:
Removing the “Probability Threshold”
Eliminating the complexity of multiple credit impairment models / balance sheet goals
But why is this important?
How is this expected to improve the reasonableness and/or reactiveness of our reserve estimates?

5. Banking LLR’s Banking Crises Financial Crisis Loan $ increased 44%
Slide Source: July 21, 2016 FASB Webinar
Loan $ increased 44%
LLR $ decreased 10%
Loan $ increased 70%
LLR $ decreased 8%
Highlights need for additional FASB guidance as loans and reserves are directional inconsistent

6. Credit Union LLR’s Financial Crisis Loan $ increased 23.86%
LLR $ increased 1,327.53%
Loan $ increased 98.85%
LLR $ increased 26.00%

7. Purpose of CECL “CECL” – Current Expected Credit Loss model
Forward looking requirements
Removes “Probable Loss” threshold
Longer loss horizon
Need for loan-level data
Overall Goal: Quicker recognition of losses.
Changes in the ALLL reserve balances under CECL will primarily reflect changes in credit quality, and flow through the Credit Union’s earnings. The hope is to improve transparency for financial statement users.

8. The Amount Expected to be Collected
Purpose of CECL
Basic CECL Equation:
Amortized Cost of the Asset – Allowance =
The Amount Expected to be Collected
(over remaining contractual life)
Where Amortized Cost represents the unpaid principal balance adjusted for deferred fees and costs, prepayments, charge offs and nonaccrual practices

9. Purpose of CECL So what has changed based on this ASU? Loans
Held-for-Investment – CECL
Held-for-Sale – Lower of amortized cost basis or market
Debt Securities
Held-to-Maturity – CECL
Available-for-Sale – Credit Losses will be recorded through an allowance (difference between amortized cost basis and fair value)
Trading – Fair Value (no change from current GAAP)
Purchased Assets with Credit Deterioration
Similar to current GAAP, but initial allowance added to purchase price rather than as provision expense

10. CECL Model vs. Incurred Loss Model

11. Incurred Loss ALLL (Current Model)
The incurred loss model currently used to estimate the Allowance for Loan Losses utilizes several different components including:
Homogeneous loan pool reserves
Non-homogeneous specific loan reserves
Reserves for qualitative and environmental (Q&E) factors

12. Incurred Loss ALLL (Current Model)
The existing method generally:
Delays recognition of credit losses until the loss is “probable”
Considers losses that will most likely be reflected as charge-offs during the next operating cycle
In practice, what is deemed to be an operating cycle may vary significantly

13. CECL vs. Incurred Loss
Life of loan losses vs. losses over the next operating cycle for collectively evaluated assets
Based on current, known factors and reasonable and supportable forecasts about the future
Concept – Every new loan originated increases exposure to credit risk
Contractual loan payments of principal and interest reduce this exposure

14. CECL vs. Incurred Loss

15. Data Inputs
Current Expected Credit Loss model will be based on information such as:
Past events
Historical loss experience
Current conditions
Borrower credit worthiness
-and-
Forecasts of expected credit losses
Current point and forecast direction of economic cycle
Hmmm, not
a fan of the last two

16. Data Inputs
FASB expects that a credit union’s estimate of expected credit losses will largely be informed by historical loss information for financial assets of a similar type and credit risk.
The expected credit loss estimate represents a life of loan estimate and considers:
Prepayments
Collateral value
Current and expected economic conditions (compared to loss history)

17. Vintage Year Concept

18. Vintage Year Model Example
Assumptions
$1 million in new loan originations per year
5 year principal payback
5 year life of loans
No prepayments
1% life of loan losses expected for each vintage
Predictable loss curve

19. Vintage Year Model Example
For this example, we begin with loans originated in 2012, since we are estimating our reserves in 2016, and 2012 is the last vintage that will have collections in 2016:

20. Vintage Year Model Example
Next, we will invert our historical and expected collections from the last slide to take a look at our historical and expected charge-offs:

21. Vintage Year Model Example
The ALLL equals the expected losses, less losses recognized to date.
The ALLL stabilizes at 0.8% in 2015.
Notice, there are no additional reserves for impaired loans!

22. Economic Cycle Concept

23. Practical Expedient for CECL Modeling
What should you do if you lack support to reasonably estimate losses over the entire remaining life of your loan portfolio?
A practical expedient is available
Revert back to historical loss information
Adjust for economic cycle expectations.

24. Effective Date
For Non-PBE’s (including credit unions) for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 31, 2021.
Early adoption is available for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years.

25. Terminology

26. Collateral Dependence
A practical expedient is available for collateral dependent financial assets
A collateral dependent asset is a financial asset for which repayment is expected primarily or substantially through:
Operation of the collateral
Sale of the collateral

27. Collateral Dependence
A Collateral dependent reserve estimate depends on reason for collateral dependence:
Operation by lender
Compare the amortized cost to the discounted fair value of the collateral
Sale of collateral
Compare the amortized cost to the discounted fair value of the collateral, less expected selling costs
NOTE: This practical expedient should not be applied to loans that do not meet the definition for collateral dependency

28. Troubled Debt Restructurings (TDR’s)
They Still Exist…
The accounting guidance for TDR’s remains largely unchanged, with the following tweaks:
No requirement to estimate reserves on TDR’s using a discounted cash flow (DCF) analysis, other measurement approaches may be used.
Subsequent modifications can remove TDR status if the terms of the new loan do not represent a TDR.

29. Purchased Financial Assets with Credit Deterioration (PCD)
ASC – Loans and Debt Securities Acquired with Deteriorated Credit Quality
Calculation Includes
Contractually Required Payments
Cash Flows Expected to be Collected
Nonaccretable Difference
Initial Investment
Accretable Yield
All of which are tracked separately

30. CECL Accounting for PCD
CHANGE – Items are no longer tracked separately but the allowance is included with the CECL allowance
Credit Union’s should estimate and record an allowance for credit losses at the time of purchase, which is then added to the purchase price rather than being reported as a credit loss expense
The remaining difference between the purchase price, plus the allowance, and the contractual cash flows is a non credit discount

31. Factors to Consider when Estimating Credit Losses on PCD
The borrowers financial condition, credit rating, credit score, asset quality or business prospects
The borrower’s ability to make scheduled interest or principal payments
The remaining payment terms of the financial asset
The remaining time to maturity and the timing and extent of prepayments
The nature and volume of the entity’s financial assets
The volume and severity of past due financial assets and adversely classified or rated financial assets
The value of the underlying collateral of the financial assets
Entity’s lending policies and procedures

32. CECL Accounting for PCD
Example:
A Credit Union purchases a pool of loans with an unpaid principal balance of $1,000,000 for $750,000. Based on the Credit Union’s experience with the selling institution and previous losses on these types of loans, the expected loss is 15%.
Non Credit Discount (Accretable)
$100,000
Allowance
$150,000
Contractual Cash Flows
Purchase Price
Amortized Cost Basis
$750,000

33. Disclosures

34. CECL Disclosures Disclosure goals for user understanding:
Credit risk inherent in the portfolio
Credit quality indicators for all classes
Except LOC’s and credit cards
Disaggregated by vintage year for 5 years
How management monitors credit quality
Estimate of expected credit losses
Changes in the estimate that have taken place during the current period

35. CECL Disclosures – Non PBE’s

36. Available-for-Sale Debt Securities

37. Current vs. Future Current Accounting CECL Accounting
All unrealized gains and losses on available-for-sale securities are recorded through Other Comprehensive Income
Two types of unrealized losses
Decline due to Credit Losses
Recorded through an allowance
Decline due to Other Factors (Interest Rate Risk, Market Risk, Currency Risk, or Other Price Risk)
Recorded through OCI

38. Differentiating between Credit Losses and Other Factors
Credit Loss Considerations
Do NOT Consider
Extent to which the fair value is less than the amortized cost basis
Adverse conditions specifically related to the security, an industry or geographic area
Payment structure of the debt security
Failure of the issuer of the security to make scheduled interest or principal payments
Changes to the rating of a security by a rating agency
The length of time a security has been in a loss position.
By itself OR in combination with others

39. Recommendations during the Implementation Phase

40. Effect of Initial CECL adoption
Credit unions will adopt CECL by posting a cumulative-effect adjustment to their statement of financial condition (undivided earnings) as of the beginning of the first reporting period in which the guidance is effective.
Suggestion: Estimate the impact of this adjustment well ahead of effective date for capital planning purposes.

41. Forming an Implementation Committee
Forming a Committee
Look at how the ALLL estimate flows through the credit union, and how many business areas touch it
Strive for senior level representation
Define Roles of the Committee
Set objectives and timelines
Determine responsibilities and scope out resource requirements
Provide regular updates to senior management and the Board
Create a Project Plan
Regularly update your plan
Meet regularly, as defined by the plan

42. Defining Roles for the Committee
Additional Considerations
CECL will require collaboration across functional areas and a variety of disciplines
Committee members must understand their roles during the design and implementation of CECL
Assumptions used for the ALLL under CECL will need to be consistent across other functions and models (ALM & Stress testing)
An active committee will create a system of checks and balances
Ideally, CECL should be viewed as an opportunity to improve the ALLL process

43. Factors for the Committee to Consider
Methodology Changes
There will not be one “right way” to accomplish CECL, but we would expect most credit unions will need to alter their current ALLL estimate methodology
Historical Losses
Migration Analysis
Probability of Default / Loss Given Default
Vintage Analysis
Defining economic cycles
Reasonable and supportable forecast
Model validation
Internal controls
External provider?
Data Requirements
Capital Adjustment
Communication
Projected Impact

44. Factors for the Committee to Consider
Methodology Changes
Build and maintain a data warehouse
Assessing availability and quality of historical data
Determining key data necessary for the methodology you select
Data validation process
Report building process
Gather industry data
Gather economic data
Data Requirements
Capital Adjustment
Communication
Projected Impact

45. Factors for the Committee to Consider
Methodology Changes
Need to increase current capital?
Timing considerations
Management and Board Education
Regulatory communications
Data Requirements
Capital Adjustment
Communication
Projected Impact

46. Factors for the Committee to Consider
Methodology Changes
Training and education of CECL with the Board and Senior Management
Document new policies and procedures
Periodic meetings
Documents read into the Board minutes
Data Requirements
Capital Adjustment
Communication
Projected Impact

47. Factors for the Committee to Consider
Methodology Changes
Run scenarios to test initial model(s)
Perform during the years leading up to the effective date for CECL
Refine model(s) based on results
Net income projections due to changes in provision
Peer comparisons will change
ALM impact
Stress testing
Loan pricing
Underwriting guidelines
Data Requirements
Capital Adjustment
Communication
Projected Impact

48. Data Components by Methodology
Individual loan risk classifications
Migration between classifications
Individual loan origination dates
Individual loan origination amounts
Individual loan charge-offs
Individual loan recoveries
Individual loan balances
Individual loan pool segmentation
Individual loan duration
Migration Analysis
Vintage Analysis
Data Components by Methodology
Historical Losses

49. In the Meantime….. Challenges
Regulatory and auditor unknowns
Reasonable and supportable forecasts
Economic cycle
Granularity of Loan Pools
Life of loan estimates
Expected increase to your ALLL?
Potential underwriting implications?

50. In the Meantime… Learn about acceptable methods
Historical loss rates
Migration
Regression
Vintage Year
Probability of default times loss severity
Risk rating categories (static pool analysis)
Determine data availability
Determine quantity of data
Can use different methods for different loan types
Investigate sources of industry data

51. Questions?

52. Richard Huff, CPA Principal Philadelphia, Pennsylvania
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