Since the Financial Accounting Standards Board (FASB) announced the transition to Current Expected Credit Losses (CECL) on June 16, 2016, credit unions have been working to prepare for the implementation deadline on January 1, 2023 (but December 31, 2022 for all intents and purposes).
We’ve received a lot of questions about CECL, how to transition, the role of data in the new standard, and more. A lot of these questions can only be answered on a case-by-case basis for individual credit unions. But I want to dig into what we’ve learned broadly about planning for CECL and using data to do so.
What CECL Means for Credit Unions
CECL was put in place as a reaction to the housing crisis and great recession—one of the many changes made since then in efforts to prevent another crash. Leading up to the crash, loans were growing, but allowances for loan loss weren’t growing in tandem because financial institutions weren’t experiencing losses.
Once the crash happened, institutions drastically increased their allowances for loan and lease losses (ALLL). But at that point, it was too late. The ALLL is generally reactionary and accounts only for losses expected over the next twelve months.
The goals of CECL are to be more proactive in accounting for expected losses and to look at the full life of a loan, whether it’s credit card credit, auto loan, or a mortgage. Unlike ALLL, CECL looks at:
- How much loss is expected before all loans in a portfolio are paid off
- How might the economy change going forward
- How loan age impacts payback trends
CECL is one more way for financial institutions to calculate risk, establish “what if” scenarios, and maintain proper allowances to cover credit loss.
The Role of Data in CECL Calculations
The FASB doesn’t require a specific model for calculating credit loss under CECL, but no matter what approach you use, data is central. After all, how do you attempt to predict the future? You look at historic and forecasted data.
There are a few common data points that are helpful in calculating expected credit loss:
- Existing loan portfolio data for your credit union
- Loan data from peer credit unions
- Data from the Federal Housing Finance Agency (FHFA)
- Metro-level home value data
- Metro-level unemployment data
- Other collateral value data
For credit unions with detailed data on their current loan portfolio, like many of our 2020 Analytics clients, models can use historic data to predict individualized outcomes. For credit unions without historic data—either in an usable format or no access at all—there’s industry-wide comparison data that can be used to provide estimates.
Having said that, I’d be remiss if I didn’t mention that there’s no time like now to get your loan portfolio data cleaned and analyzed by our experts at 2020 Analytics. Doing so not only helps with CECL preparation, but also helps you make better decisions about lending in general.
Data has played an increasingly vital role in credit union decisions-making, and it’s only going to continue to get more important. If you’re looking to get your loan portfolio data in order and use it for making strategic decisions, let’s talk.
Adjusting from Loan Loss to Credit Loss
There are a lot of ways to think about the move from ALLL to CECL and how to manage your allowance through the transition. There’s the “right” way, which goes against human nature. In theory, credit unions shouldn’t adjust allowances for CECL until January 1, 2023. However, as evidenced by this blog post and many others, we’re all thinking about it now.
The pandemic created a scary situation. Most credit unions increased their allowances and are seeing they might now be over-reserved (which, knowing what we know, was still probably the right move). With an higher-than-usual current allowance and a likely increase in allowance on January 1, 2023, credit unions have options:
- Keep reserves high through CECL implementation so the change is less drastic
- Start reducing reserves now and make the CECL adjustment as scheduled
Because we know CECL is coming, it’s human nature to want to plan for it and use option 1. But the “right” way is to adjust your current ALLL how you would if CECL weren’t in our future. In general, we recommend shrinking over-reserved allowances in the next year and not considering CECL into calculations until it’s time.
I’ll explain the benefits of this approach, but first, a story.
Let’s pretend this story is hypothetical. I’m pretty sure the statute of limitations is (excuse me, would be) up, but better safe than sorry.
When I was in college, I (allegedly) used a fake ID to get into bars for about 18 months before I turned 21. I’m a creature of habit, so I went to the same bars and the same liquor stores for that whole time. So the bouncers and cashiers all thought I was already 21 or 22.
Well, on my 21st birthday, I actually was 21 and could start using my real ID. I made the switch, and the bouncers and cashiers noticed. “Wait, you just turned 21?” At that point, they knew I either had to have been using a fake ID previously or was using a fake ID now…and we all know the more likely scenario.
A credit union’s allowance is like the ID. If you’re over-reserved now and don’t have to make an adjustment on January 1, 2023, it’ll be obvious then, even if it’s not right now. Auditors will notice and ask questions. If you don’t have to increase your allowance much for CECL, how weren’t you over-reserved? One of the calculations has to be wrong—one of the IDs has to be fake. Either the previous allowance was off or the new allowance is because we can’t have it both ways.
Since many credit unions are over-reserved currently, after increasing allowances in the pandemic, most should start to shrink reserves between now and when CECL goes into effect. If your allowance is inflated, you’re missing out on benefits of a right-sized reserve. In the short term, reducing your loss allowance increases your net income.
“But then won’t we take a bigger hit in 2023?” you might ask.
Not really. Upon the switch to CECL, you’ll make a “prior period adjustment,” which is just an adjustment to retained earnings and doesn’t impact income. You’re not taking a loss.
The adjustment on January 1, 2023 will have an impact on net worth, however. So it’s important to adjust budgets and to communicate with your board and other stakeholders about the change and how it might impact some of your numbers. But since the industry is making this change together, in one fell swoop, we’ll all be experiencing similar shifts. Think of it like an industry-wide asterisk next to Q1 2023.
How 2020 Analytics Helps with CECL Calculations
This is a lot. I know. It’s a big topic and a big shift, and each credit union has questions about how to handle the transition.
In most cases, the answer is, “It depends.”
Thankfully, with data, we can help each credit union come up with their best solution.
Inside the TTA DataVision Portal, we’ve built models and reports that help credit unions use their historic loan portfolio data (or industry data if that’s not available) to determine CECL allowances based on likely future economic scenarios.
The vintage analysis, one of FASB’s recommended models, credit unions can see, based on their own past loan loss data, how to account for future credit loss.
For credit unions that don’t have historic data, there’s still the probability of default (PD) model that uses industry data to calculate risk of loss. Credit unions that do have historic data can use this model as well. Just because you haven’t had charge-offs on a loan cohort to date doesn’t mean you won’t in the future. In addition, this model also looks at a metro area analysis, which takes into account fluctuations in local real estate values and unemployment. See an example metro area analysis.
You can view an example CECL analysis report here. Once we have your data in the TTA portal, we can help you run analyses, calculate expected credit loss, and make recommendations for transitioning as we move toward January 1, 2023. Plus, when it’s audit time, you have a full accounting of the data and models that were used to calculate your allowance. It’s a handy paper trail to have as the industry moves into a new accounting era.
CECL is a big topic on everyone’s minds, even as we’re told to not consider it until December 31, 2022. If you have questions about it or want to see how the TTA portal can give you insight into planning, request a demo.
Dan Price, CPA, CFA
President, 2020 Analytics