OK, so Current Expected Credit Losses (CECL) might not be as flashy as JPMC’s new payment acceptance device, Synchrony’s new Work At Home Strategy, American Express’ sprint to rebuild the Amex Delta card, or Discover’s new College Planning Tool. Accounting is not exactly exciting, but it keeps the financials organized and you out of trouble with regulators.
A few weeks ago, the Department of Treasury filed a report titled “The Current Expected Credit Loss Accounting Standard and Financial Regulatory Capital.” Well, it might not be the best thing to read at the beach, but unless you live in a place like Florida, the summer is over anyway.
Mercator Advisory Group’s primer on CECL is classic and available in our library; it provides credit managers with practical information. The Treasury’s new report explains the impact to financial services in the context of COVID-19. Even though the regulation seemed too rigorous, it has been vital in keeping credit card companies and financial institutions out of trouble during the current economic mess. Right now, no one knows which way loan losses will go over the next 24 months. It is better to be conservative than aggressive in upcoming forecasts.
CECL also brings the U.S. market up to speed with the rest of the world.
In the Mercator report, we summarize the change in this way: “A new Financial Accounting Standards Board (FASB) rule requires credit card issuers to shift from Allowance for Loan and Lease Loss (ALLL) measure to account modeling, which will increase credit loss expenses and further diminish credit card profitability.”
Now, down to brass tacks. First, the mundane:
- Over the years, stakeholders have discussed and debated the potential effects of CECL on financial institutions and their regulatory capital and lending practices. These issues have included whether (1) CECL may have procyclical effects and reduce financial institutions’ capacity to lend, particularly in economic downturns; (2) CECL’s anticipated benefits justify its implementation costs and other burdens; (3) financial institution capital frameworks should be recalibrated in response to CECL; and (4) CECL may have disparate effects on certain types of lenders and lending.
- Treasury supports the goals of CECL—including to provide users of financial statements with the more forward-looking information and to present assets on financial statements in a manner that reflects amounts expected to be collected. Treasury also recognizes the seriousness of the concerns that have been raised regarding CECL’s potential effects on and implications for regulatory capital, lenders, borrowers, and the U.S. economy.
Now, the thrill for accountants:
- To understand CECL and its potential effects on financial institutions’ regulatory capital, it is important to understand the previous standard, the incurred loss methodology (ILM), and the decision by FASB, which is the U.S. accounting standard-setting body, to transition from ILM to CECL.
- For the 45 years before 2020, ILM was the standard for determining allowances for loan and lease losses (ALLL) under GAAP. Under ILM, a firm recognizes credit losses only when, based on information available upon preparing the financial statement, (1) it is “probable” that a loss will have been incurred at the date of the statement, and (2) the firm can reasonably estimate the amount of the loss.5 In judging whether a loss is probable under ILM, a firm can use current and past information but cannot consider potential future events that might cause a loss
The short story is that instead of realizing losses as accounts age to chargeoff at 185 days delinquent, credit card companies must be in front of the issue. They need to understand the vulnerability of each account at the account level. You can no longer say that a vintage of credit card accounts, like those booked in October 2018, had FICO scores averaging 724, and they typically charge off at a 2.8% rate. You must have an accurate assessment of how vulnerable each account is, then all loan loss reserves accordingly—in advance of the chargeoff.
On the net effect, the report says:
- As a result, CECL will generally require financial institutions to establish more significant credit loss allowances than under ILM. That is, CECL will generally increase a financial institution’s allowance for credit losses relative to its ALLL. All else equal, an increase in credit loss allowances will reduce the institution’s GAAP net income—and thus its retained earnings.
It is not “one and done;” it is the new way to run the business.
- Financial institutions are impacted by CECL through a potentially significant “day-1” impact and their ongoing quarterly adjustments to their allowances for credit losses over the lives of loans and other financial assets. Upon its adoption of CECL, a financial institution must record a one-time adjustment to its allowances to reflect the difference, if any, between allowances required under ILM and CECL.
CECL might not sound exciting, but it shields against unexpected events, like a global pandemic. Investors watch this every day.
Overview by Brian Riley, Director, Credit Advisory Service at Mercator Advisory Group