FINANCIAL ACCOUNTING STANDARDS BOARD: CURRENT EXPECTED CREDIT LOSS MODEL

Transcription

1 FINANCIAL ACCOUNTING STANDARDS BOARD: CURRENT EXPECTED CREDIT LOSS MODEL WHAT WILL BE THE IMPACT? CAPSTONE PROJECT AMERICAN BANKERS ASSOCIATION STONIER GRADUATE SCHOOL OF BANKING PETER G. BAILEY PRIMATICS FINANCIAL

2 Contents Executive Summary... 5 About Primatics Financial... 7 Problem Statement... 8 Summary... 8 Background... 8 FASB Objectives... 9 Who is Impacted?... 9 Main Provisions Differences From U.S. GAAP Industry Feedback Next Steps Financial Statement Implications Approach Loan Loss Reserve Trends Primatics Financial - CECL Impact Analysis Summary Assumptions Approach Analysis rd Party Service Providers Operational Challenges Summary People Process Technology Data Summary of Findings Recommendations Bibliography Appendix Acronym Summary P a g e

3 CECL Preparedness P a g e

4 Table of Figures Figure 1: Non-Performing Assets / Total Assets (%) Figure 2: Loan Loss Reserves / Gross Loan Balance (%) Figure 3: Loan Loss Provision / Average Loans Balance (%) Figure 4: Allowance / Non-Performing Assets (%) Figure 5: Sample Bank Size Figure 6: Sample Bank Loan Portfolios Figure 7: Asset Class Incurred Loss Rates Figure 8: Sample Bank ALLL (Incurred Loss) Figure 9: ALLL Comparison (Base) Figure 10: ALLL under CECL (Economic Scenarios) Figure 11: Comparison of CECL to Probable Loss Reserve (Milliman) P a g e

5 Executive Summary This paper will evaluate the impact of the Financial Accounting Standards Board (FASB) proposed changes to the way financial institutions reserve for credit losses, and offer a set of recommended next steps for the impacted financial institutions. The proposed changes are commonly referred to as CECL, an acronym for Current Expected Credit Loss and will require a forward looking reserving process, in contrast to the current incurred loss model in practice today. If issued, the proposed accounting standards update will have a major impact on most financial institutions, and has been one of the most hotly debated topics in the industry since the FASB issued the Accounting Standards Update (ASU), Financial Instruments - Credit Losses (Subtopic ) on December 20, FASB constituents each have a unique perspective and interest in the final guidance and implementation of CECL. Investors seek transparency in management's expectation of total losses, and a standard that is easy to understand, evaluate and compare expectations across companies. Regulators must enforce safety and soundness standards and ensure that the Allowance for Loan and Lease Losses (ALLL) is a fair representation of an institutions expected losses. Bankers very simply, seek to minimize cost to comply and complexity. While FASB's stated objective in issuing the proposal is to "provide financial statement users with more decision-useful information about the expected credit losses on financial assets", it is clear that this objective will not be achieved without a major impact on the industry. First and foremost, CECL will likely increase an institution s Loan Loss Reserves (LLR), or ALLL, between 15% and 50%. The increase will be more dramatic for banks and financial institutions with large loan portfolios. Such an increase to LLR will continue to stress an institutions capital position, as they will be required to provide for a greater level of reserves (i.e., hold more capital against extended credit). The shift from an incurred loss model to a forward looking model will require institutions to consider more factors over a significantly longer time horizon, including forecasts of future economic conditions. The long forecasting horizon, coupled with the introduction of new factors influencing the loss forecast, will lead to increased volatility, likely to require an increased capital buffer, which will limit the dividend paying capabilities of certain banks and financial institutions. A forward looking reserving process will introduce significant operational challenges and costs to comply. Compliance with CECL, including the implementation of new processes enabled through a technology solution, will impact organizations people, processes, and technology. The proposed standard will introduce new risk management complexity, greater disclosure requirements, and will likely include a transitional period where current and new processes are run in parallel for some time. As such, organizations should be prepared to grow existing resource pools, in addition to evaluating the skills of the team supporting the current reserving process. While most new accounting standards introduce new processes and controls, CECL will require traditional accounting and credit groups to 5 P a g e

6 collaborate more effectively. Both the accounting and credit views will be necessary to determine the method and information used to calculate the reserve. Finally, organizations will need to re-evaluate the systems landscape and current functionality of existing technology. CECL will require an enterprise technology solution that offers a dynamic data capture framework, integrates a robust accounting engine with a model execution platform that is capable of generating life of loan expected losses, and maybe cash flows, as well as granular reporting and analytics in support of the new disclosure requirements. It is unlikely that current systems will be able to accommodate the requirements, as most technology systems are already being stretched beyond their core functionality. Organizations will need to think strategically about addressing these challenges, and should evaluate options that not only offer a solution to comply with CECL, but a should consider implementing a platform that will enable flexibility in accommodating future changes, as the industry continues the shift towards tighter integration between risk, finance, and technology. This paper summarizes the current state of FASB's CECL proposal, including a review of the objectives, impacted parties, main provisions, industry feedback, and timing of next steps. From there, the paper explores the expected range of impact that CECL will have on (1) an institution s financial statements, and (2) the operational challenges in complying with the proposed standard. The findings are summarized and a recommendation is offered for how institutions should move forward. 6 P a g e

7 About Primatics Financial Primatics Financial ("Primatics") is an organization focused on addressing financial institutions most complex finance and risk challenges, and offers integrated technology solutions to many of the largest and most prominent financial institutions in North America. We provide solutions for Loan Accounting and Forecasting, Credit Risk and Reserving, Loan Modeling, and Loan Reporting and Analytics. FASB's proposed accounting standards update will have a direct impact on (1) all of Primatics' customers, and (2) our EVOLV software and Reserving Solution. The EVOLV Credit and Reserving Solution addresses all aspects of reserving across ASC 450 (FAS 5), ASC (FAS 114),and ASC (SOP 03-3) from data management, to reserve modeling, to impairment testing, and all the way through required disclosures and analytics. Most reserving solutions in the market today attack certain aspects of the reserving process, such as the roll-rate model, or the reserve calculation; however, they fail to manage the entire end-to-end process and do not provide scalable technology to meet a financial institutions growing needs. In addition, these point solutions do not integrate well within a institutions overall technology architecture. EVOLV connects various processes so that data can flow from a financial institution s core banking system to the modeling system and to the reporting module. This architecture allows EVOLV to access data inputs, such as charge-offs, to automatically calculate modeling loss rates. While other solutions may stop after producing loss rates, the Credit and Reserving Solution enables reserves to be maintained at the loan-level with key reporting data that automate the disclosures and empowers users with a dynamic analytical framework. EVOLV automates a financial institution s numerous manual processes, reducing risk of data and calculation errors while increasing audit capabilities and decreasing reconciliation routines As an organization, we view CECL as a tremendous business opportunity. The proposed guidance will impact all banks and financial institutions, and will require the industry to evaluate solutions to better integrate traditionally isolated functions, including loan operations, credit risk, finance, and reporting. Primatics is focused on empowering institutions to address the intersection of Risk and Finance with dynamic technology solutions. Commencing with FASB's original ASU issuance in December 2012, Primatics has invested significantly in developing a technology platform and software solutions that will lead the lead the market for complying with CECL. As a result of this focus, Primatics has become a thought leader around CECL in the industry, leading webinars, speaking at industry conferences, and publishing numerous articles in respected publications. This paper brings together many of the common themes we have expressed over the past few years. 7 P a g e

8 Problem Statement Summary The proposed Current Expected Credit Loss (CECL) model will have a significant financial statement and operational impact on all financial institutions. Compliance with CECL will result in increasing Loan Loss Reserves, effectively reducing an institutions overall income. This increase to the Allowance will impact capital ratios, requiring most institutions to hold more capital. Additionally, there will be significant operational challenges and costs to educate, prepare, and implement solutions that will enable compliance with the proposed standard. Background Before the global economic crisis that began in 2008, both the FASB and the International Accounting Standards Board (IASB, and collectively the "Boards") began a joint project to revise and improve their respective standards of accounting for financial instruments, with a primary objective to achieve one converged international standard to account for financial instruments impairment In the aftermath of the global economic crisis, the overstatement of assets caused by a delayed recognition of credit losses associated with loans (and other financial instruments) was identified as a weakness in the application of existing accounting standards. Specifically, because the existing "incurred loss" model delays recognition until a credit loss is probable (or has been incurred), the Financial Crisis Advisory Group (FCAG) 1 recommended exploring alternatives to the incurred loss model that would use more forward-looking information. The inherent complexity of having multiple credit impairment models was identified as an additional weakness of existing accounting standards. The current reserving framework includes multiple standards and models, each with its own unique complexities. Financial institutions are faced with challenge of interpreting the standards and building out separate processes to support each. Historically, it has been a big challenge just for institutions to identify which assets belong in which population. Separately, investors are faced with the unenviable task of interpreting an institutions reserve, and breaking down the individual pieces to evaluate risk, and compare to other institutions. The reserving framework for held-for-investment (HFI) loans provides an example of the multiple models, and associated complexities. The following standards are applicable to HFI loans: General Reserve (ASC 450, formerly FAS 5) - Addresses the accounting for impairment of certain loans, and is generally applicable to large groups of smaller-balance 1 The Financial Crisis Advisory Group (FCAG) was created in October 2008 by the FASB and the IASB, as part of a joint approach to dealing with the reporting issues arising from the global financial crisis. The FCAG was asked to consider how improvements in financial reporting could help enhance investors confidence in financial markets. 8 P a g e

9 homogeneous loans that can be collectively evaluated for impairment. The standard requires institutions to include both quantitative and qualitative components in the evaluation. Both the quantitative and qualitative components can be supported by various methodologies, which are documented in an institutions ALLL Methodology documentation. Asset Specific Reserve (ASC , formerly FAS 114) - Addresses the accounting by creditors for impairment of certain loans, and is generally applicable to all loans, uncollateralized as well as collateralized, except large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment (FAS 5). It also applies to all loans that are restructured in a troubled debt restructuring involving a modification of terms. It requires that impaired loans that are within the scope of this Statement be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Purchase Credit Impaired (ASC , formerly SOP 03-3) - Applied to acquired loans where there is significant doubt about the collection of the contractual terms of the loan. The standard requires life-of-loan expected cash flows to be forecasted and discounted by the effective accounting yield to evaluate for impairment. SOP 03-3 is often referenced as the current model that most closely resembles the proposed standard, as a result of the forward looking expected cash flow expectations. FASB Objectives FASB stated the main objective in developing the proposal was to provide "financial statement users with more decision-useful information about the expected credit loss on financial assets and other commitments to extend credit held by a reporting entity at each reporting date" (FASB ASU, pg 5). This objective would be achieved by replacing the current impairment model, which reflects incurred credit events, with a model that recognizes expected credit risks and by requiring consideration of a broader range of reasonable and supportable information to inform credit loss estimates. These proposed amendments also would reduce complexity by replacing the numerous existing impairment models in current U.S. generally accepted accounting principles (GAAP) with a consistent measurement approach. Who is Impacted? All entities that hold financial assets that are measured at amortized cost and are exposed to potential credit risk would be affected by the proposed amendments. Loans, debt securities, trade receivables, lease receivables, loan commitments, reinsurance receivables, and any other receivables that represent the contractual right to receive cash would generally be affected by the proposed amendments. 9 P a g e

10 Main Provisions The proposed amendments would require an entity to impair its existing financial assets measured at amortized cost on the basis of the current estimate of contractual cash flows not expected to be collected as of the reporting date. This impairment would be reflected as an allowance for expected credit losses. The proposed amendments would remove the existing probable threshold in U.S. GAAP for recognizing credit losses and broaden the range of information that must be considered in measuring the allowance for expected credit losses. More specifically, the estimate of expected credit losses would be based on relevant information about past events, including historical loss experience with similar assets, current conditions, and reasonable and supportable forecasts that affect the expected collectability of the assets remaining contractual cash flows. An estimate of expected credit losses would always reflect both the possibility that a credit loss results and the possibility that no credit loss results. Accordingly, the proposed amendments would prohibit an entity from estimating expected credit losses solely on the basis of the most likely outcome. As a result of the proposed amendments, financial assets carried at amortized cost less an allowance would reflect the current estimate of the cash flows expected to be collected at the reporting date, and the income statement would reflect credit deterioration (or improvement) that has taken place during the period. In addition, the Board is still debating whether or not to include Available-for-Sale (AFS) securities in the CECL model. There have been tentative board decision to remove AFS securities from the general CECL model, but have noted that this will require changes to the current Other than temporary impairment (OTTI) guidance such that the allowance can be reversed. Differences From U.S. GAAP Current U.S. GAAP includes five different incurred loss credit impairment models for instruments within the scope of the proposed amendments. The existing models generally delay recognition of credit loss until the loss is considered "probable." This initial recognition threshold is perceived to have interfered with the timely recognition of credit losses and overstated assets during the global economic crisis. The credit loss recognition guidance in the proposed amendments would eliminate the existing "probable" initial recognition threshold in U.S. GAAP, and instead reflect the entity s current estimate of expected credit losses. Furthermore, when credit losses are measured under current U.S. GAAP, an entity generally only considers past events and current conditions in measuring the incurred loss. The proposed amendments would broaden the information that an entity is required to consider in developing its credit loss estimate. Specifically, the proposed amendments would require that an entity s estimate be based on relevant information about past events, including historical loss experience with similar assets, current conditions, and reasonable 10 P a g e

11 and supportable forecasts that affect the expected collectability of the financial assets remaining contractual cash flows. In addition to considering quantitative and qualitative factors specific to the borrower, including the entity s current evaluation of the borrower s creditworthiness, an entity also would consider future conditions and an evaluation of both the current point in, and the forecasted direction of, the economic cycle. For example, changes in issuer or industry-wide underwriting standards or expectations for market performance should now be considered. It is worth noting that while the Boards began working together in an effort to address perceived weaknesses in the guidance relating to the delayed recognition of credit losses and the complexity of multiple impairment models, the Boards have since taken divergent paths. In July 2012, FASB decided to revisit previous tentative decisions, while the IASB continued to develop the three-bucket impairment model. In July 2014, the IASB issued the final publication of IFRS 9 Financial Instruments. This paper will focus on FASB's proposed changes. Industry Feedback FASB issued the Accounting Standards Update (ASU), Financial Instruments - Credit Losses (Subtopic ) 2 on December 20, 2012, with the comment period ending on May 31, FASB conducted investor meetings, field visits and received comment letters from interested parties to understand whether the proposed Update would achieve FASB's mission to improve financial reporting, and to better understand the operational impact and costs of applying the proposed Update. Feedback was provided by preparers, professional organizations, public accounting firms, individuals, regulators, and government agencies. Investors were overwhelmingly in favor, by a nearly 3-1 margin, of a model that recognizes all expected credit losses at origination. Most investors said that they "view the allowance as representing capital set aside to absorb future expected credit losses and in this regard reserve adequacy is of paramount importance" (FASB Feedback Summary). In addition, investors noted they would like to see more robust disclosures on credit losses. For example, reports that compare expected vs. actual performance, asset performance by origination vintage, and reports that attribute changes in the allowance to specific factors as investors desire transparency into management's ability to forecast expected losses. Not surprisingly, financial institutions or "preparers" did not support the proposed Update. The community of financial institutions expressed a resistance to change, as they prefer a model that either recognizes only some of the expected credit losses or maintains a threshold that must be met before all expected credits losses are recognized. These financial institutions raised significant concerns with a potential negative impact on regulatory capital, and the operational hurdles to comply with the proposed Update. In 2 For ease of reference, we will refer to FASB's Accounting Standards Update, Financial Instruments - Credit Losses (Subtopic ), as the "Update". 11 P a g e

12 support of the capital concerns, one industry analysis noted "financial institutions may be unwilling to lend because the extension of credit will reduce the entity's capital position, which would be amplified when an entity is growing, as an entity would be required to provide for greater levels of reserves as its portfolio increases in size" (Milliman). While the impact on regulatory capital seems to be driving resistance to support the proposed Update from the larger institutions, the operational burdens to comply are of greater importance to the community and regional institutions. As the industry continues to face tightened spreads and compressed net interest margins, there has been a laser focus on reducing operating costs and optimizing efficiency ratios. Any and all operational costs are being scrutinized, and some smaller institutions fear that the significant operational costs to comply with CECL could force them to the breaking point. Regulators offered a unique perspective on the timing of the proposal. In a speech in front of the American Institute of Certified Public Accountants (AICPA), the Comptroller of the Currency discussed how the current credit cycle has provided the perfect opportunity to recalibrate during this down cycle 3. Thomas J. Curry stated, "President John F. Kennedy once said that 'the time to repair the roof is when the sun is shining'... Few of us would go so far as to call today s uncertain environment 'sunny,' but we have undoubtedly come a long way over the past five years in addressing the big back log of deferred maintenance in bank regulation. Indeed, we are well down the road with perhaps the most comprehensive overhaul of the banking rules in the nation s modern history" (Curry). Next Steps At the time of authoring this paper, the final standard has not been issued and the effective date has not been set. Wording of the final standard will be critical in influencing how CECL will be implemented. At the time of issuance of this paper, it is expected that the FASB will issue the final guidance in the second or third quarter of A reference, that as a result of investments in the economy, and specifically to the Banking industry, the credit cycle is extremely benign and the industry is experiencing historical lows in non-performing assets and credit losses. 12 P a g e

13 Financial Statement Implications Approach This section will look explore the expected range of financial statement impact that CECL will on financial institutions. To provide context, I have offered a high level summary and analysis of historical data, trends, and financial financial ratios that investors often consider when evaluating a institution's portfolio performance, credit risk and reserve adequacy. Through this analysis, I offer an opinion on why the FASB may have determined that a change from the incurred loss model to a forward looking expected loss model would benefit the industry. After providing context through an analysis of LLR trends, I will review a direct data analysis performed by Primatics Financial. Here, I will discuss the approach, assumption, results and analysis of the estimated impact that CECL will have on a financial institutions Allowance. In addition, this section also includes a summary of a study performed by Milliman, a third party service provider, that offers a unique comparison of incurred loss to expected loss on a consumer portfolios. Loan Loss Reserve Trends This section provides an analysis of data, graphs, trends, and specific ratios that are commonly considered in an investor s evaluation of an institution s loan portfolio performance and reserve adequacy. All data has been extracted from SNL's database and is for the period from 2000 to the third quarter in 2014 (9/30/2014). The data includes historical information from some of largest financial institutions in the United States, including: 1. JP Morgan Chase 2. Bank of America 3. Wells Fargo 4. US Bancorp 5. PNC Financial Services 6. Capital One In addition to these large 'Tier 1' financial institutions, the analysis includes historical data from regional and community banking institutions. To do this, I have included averages from the two separate peer groups, one representing a regional banking institutions, and one representing a smaller regional banking institutions. The following Peer Groups were used: 1. Tier 2 Peer Group - Trustmark National Bank peer group. Trustmark is a regional bank based out of Jackson, Mississippi with ~$12 billion assets. 13 P a g e

14 NPA (% of Assets) 2. Tier 3 Peer Group' - Bank of Missouri peer group. Bank of Missouri is a community bank based out of Perryville, Missouri with ~$1 billion assets. The inclusion of the above Peer Groups provides a more diverse collection of financial institutions to evaluate. Figure 1: Non-Performing Assets / Total Assets (%) Tier 3 Peer Group JPMorgan Chase & Co. Bank of America Corp. Wells Fargo & Co. U.S. Bancorp PNC Financial Services Group Tier 2 Peer Group Summary: Figure 1 compares a financial institutions total non-performing assets (NPA) to its Total Assets. This measure is referred to as a NPA Ratio, and is often used to evaluate the current risk profile of an institutions loan portfolio. A lower percentage of NPA would indicate a higher credit quality loan portfolio. Analysis: In review of Figure 1, the percentage of NPAs starts to increase in This increase corresponds to the early stages of the credit crisis. As the economic conditions worsened, more and more borrowers began to default on their debts, and the percentage of NPAs grew rapidly through A increasing NPA Ratio is a good indicator of deteriorating credit quality. Even after three years of a relatively benign credit cycle, we can still see that the lingering effects of the credit crisis, with the NPA Ratio higher than the historical averages of pre P a g e

15 Loan Loss Reserve (% of Gross Loans) Figure 2: Loan Loss Reserves / Gross Loan Balance (%) JPMorgan Chase & Co. Bank of America Corp. Wells Fargo & Co. U.S. Bancorp PNC Financial Services Group Capital One Financial Corp. Tier 2 Peer Group Tier 3 Peer Group Summary: Figure 2 compares a financial institutions Loan Loss Reserves (LLR) to its Gross Loan Balance. This measure is referred to as the Allowance Ratio, and is often used to evaluate the adequacy of a institutions reserves for credit losses. Reserve levels between 1% - 2% are common in normal credit cycles. Analysis: Figure 2 shows that most institutions were decreasing their reserve levels heading into the credit crisis. The increases in loan reserves did not start until 2007, with drastic increases in 2008 and 2009 as a reactionary measure to the deteriorating credit quality depicted in Figure 1. This counter to the belief and reasonable expectation that a institution should be increasing it's as risk indicators were identified in the period leading up to the credit cycle. Under the proposed CECL guidance, institutions would likely have been increasing loan reserves well in advance of 2007, as these indicators of expected credit losses were identified. The one exception is Capital One, who held significantly more reserves than the industry average, which is likely a result of their business model and heavy concentration of credit cards, a traditionally higher risk asset class requiring larger reserves. 15 P a g e

16 Provision (% of Avg Loans) Figure 3: Loan Loss Provision / Average Loans Balance (%) JPMorgan Chase & Co. Bank of America Corp. Wells Fargo & Co. U.S. Bancorp PNC Financial Services Group Tier 2 Peer Group Summary: Figure 3 compares a financial institutions Loan Loss Provision to its Average Loan Balance. This ratio can be used to evaluate current losses in a loan portfolio, with significant increases to the ratio reflecting higher than expected losses. A larger percentage of Loan Loss Provision to Average Loan Balance can indicate rapidly deteriorating credit performance resulting in increased charge-offs and lower income recognition. Analysis: Figure 3 clearly highlights the trend of increasing Loan Loss Provisions as percentage of Average Loan Balance in the period from 2007 to This ratio remained elevated through 2012, and has just recently begun to stabilize to normal levels of less than 1%. This increase in the Loan Loss Provision is a direct result of limited Loan Loss Reserves available to absorb the credit losses in the portfolio (i.e., increasing charge-offs greater). 16 P a g e

17 Allowance (% of NPA) Figure 4: Allowance / Non-Performing Assets (%) JPMorgan Chase & Co. Bank of America Corp. Wells Fargo & Co. U.S. Bancorp PNC Financial Services Group Tier 2 Peer Group Tier 3 Peer Group Summary: Figure 4 compares a financial institutions Allowance for Loan and Leases Losses (ALLL) to its Non-Performing Asset (NPA) balance. This measure is referred to as a Coverage Ratio, and can be used to evaluate an institutions ability to cover for the credit losses embedded in the portfolio. Analysis: Historically, various forms of the Coverage Ratio have been relied on for evaluating a institutions ability to cover for its higher risk assets. The trend depicted in Figure 4 highlights why this ratio, and Coverage Ratios in general, should not be solely relied upon when evaluating the adequacy of a institutions reserve. It would appear that each of these institutions was well positioned to cover it's, with most institutions holding an Allowance greater than 200% of NPAs. In hindsight, this was not at all the case, and the industry on average was under-reserved. A Coverage Ratio will look inflated when NPAs are low, but are not good measures when NPAs outpace the build-up of a reserve, as depicted in Figures 1-3. Each of the above analyses supports FASB's primary objective with the CECL guidance, to provide investors with better decision-useful information. In addition to the methodology updates, the CECL guidance provides an overhaul on the way institutions will report on their reserve balances. The focus will be on explaining results and helping financial statement users understand the following: 1. The credit risk inherent in the portfolio and how management monitors the credit quality of the portfolio 2. Management s estimate of expected credit losses 3. Changes in the estimate of expected credit losses that have taken place during the period 17 P a g e

18 When disclosing information, "an entity shall determine, in light of the facts and circumstances, how much detail it must provide to satisfy the disclosure requirements." Additionally, "an entity must strike a balance between obscuring important information as a result of too much aggregation and overburdening financial statements with excessive detail that may not assist financial statement users to understand the entity s financial assets and allowance for expected credit losses (FASB ASU pg 21-22)." 18 P a g e

19 Primatics Financial - CECL Impact Analysis Summary Primatics completed a CECL impact analysis to compare and contrast results of the current incurred loss approach (ASC 450, formerly FAS 5) with FASB's proposed expected loss approach (CECL). The goal of the exercise was to generate results under the proposed standard that would provide insight into the potential range of impacts that CECL could have on an institutions ALLL if the standard, in its current version, were passed. Assumptions The following assumptions were made: The analysis focused exclusively on loans collectively impaired under (ASC 450, formerly FAS 5), and excluded acquired loans (ASC , formerly SOP 03-3), troubled debt restructurings, and individually impaired loans (ASC , formerly FAS 114). The analysis used a discounted cash-flow (DCF) approach. A variety of sources were leveraged to inform the composition of the hypothetical portfolios; including regulatory filings, 10k and 10q reports and other industry sources. 4 Approach The following approach was taken to complete the analysis: 1. Construct a Sample Loan Portfolio A sample loan portfolio was constructed, consisting of common types of loans, including 1st Lien Residential, 2nd Lien Residential, Commercial Real Estate (CRE), Commercial and Industrial (C&I), and Consumer loans. 2. Create Two Sample Banks Two Sample Banks (e.g., Bank A, Bank B) were created with different asset sizes, and unique loan portfolio compositions. Figure 5 details the Sample Bank sizes and Figure 6 details the portfolio composition of the Sample Banks. Figure 5: Sample Bank Size Bank Asset Size Loan Portfolio Bank A ~$7 billion $5 billion Bank B $1.7 billion $1 billion Figure 6: Sample Bank Loan Portfolios 4 Client data was also used as a "sanity" check in the construction of the hypothetical portfolios. 19 P a g e

20 Loan Type Bank A Bank B 1st Lien Residential 30% 27.5% 2nd Lien Residential 10% 7.5% CRE 30% 45% C&I 25% 15% Consumer 5% 5% 3. Calculate ALLL under ASC 450 The Sample Banks ALLL was projected, leveraging a incurred loss model. Primatics' proprietary software, EVOLV, was leveraged to support the calculations. Figure 7 details the incurred loss rates that were used for each asset class, and Figure 8 details the resulting Allowance for each of the two Sample Banks. Figure 7: Asset Class Incurred Loss Rates Loan Type Incurred Loss Rate 1st Lien Residential 1.50% 2nd Lien Residential 2.50% CRE 1.80% C&I 1.92% Consumer 1.60% Figure 8: Sample Bank ALLL (Incurred Loss) Allowance Bank A Bank B Allowance % 1.80% 1.78% 4. Calculate ALLL under CECL The Sample Banks ALLL was projected under the CECL model, and included a projection of the ALLL under three economic scenarios (e.g., base, downturn, and recovery). To support the forward looking expected loss calculation, EVOLV's lifetime expected loss models were leveraged. The modeling approach considered: Residential loans (e.g., 1 st and 2 nd liens) were modeled using Primatics suite of proprietary mortgage models, which project future defaults, prepayments, and losses given default conditional on forecasted macro-economic assumptions. Specifically, the macro-economic assumptions considered were interest rates, house prices, unemployment, and gross domestic product (GDP). All other loan types (e.g. CRE, C&I, Consumer) loss assumptions were generated using Primatics suite of proprietary loss models, which project future loss rates conditional on forecast macroeconomic assumptions. 20 P a g e

21 Forecasted expected credit losses for three (3) scenarios, including a base scenario ("Base"), a economic downturn ("Down"), and a economic recovery ("Up"). 5. Compare Sample Bank Allowances Figures 9 and 10 compare the expected ALLL percentages calculated under the existing incurred loss model to the proposed CECL model: Figure 9: ALLL Comparison (Base) Loan Type ASC 450 CECL % Change 1st Lien Residential 1.50% 1.61% 7.33% 2nd Lien Residential 2.50% 2.97% 18.80% CRE 1.80% 2.26% 25.56% C&I 1.92% 2.32% 20.83% Consumer 1.60% 2.34% 46.25% Bank A 1.80% 2.19% 21.67% Bank B 1.78% 2.18% 22.47% Figure 10: ALLL under CECL (Economic Scenarios) Loan Type Base Up Down 1st Lien Residential 1.61% 1.45% 2.37% 2nd Lien Residential 2.97% 2.95% 3.02% CRE 2.26% 2.26% 2.37% C&I 2.32% 2.18% 2.60% Consumer 2.34% 2.02% 2.64% Bank A 2.19% 2.05% 2.51% Bank B 2.18% 2.06% 2.47% Analysis As expected, the ALLL for each Sample Bank increased significantly under the CECL model compared to the incurred loss model. The increase on Bank A was 21.67% and the increase on Bank B was 22.47%. While the individual increases were lower than Primatics' expectations, the results were within a reasonable range. The analysis noted significant variance across the different loan types: First Lien Residential (mortgages) ALLL increased by 7.33%, which represented the smallest increase across product types, an increase significantly lower than Primatics' expectations. The slight increase can be attributed to a combination of factors. The hypothetical loan portfolio included a high concentration of recently originated loans, which benefit from tighter underwriting standards, higher quality borrowers, and lower loan-to-value (LTV) ratios. In addition, the economic forecast is optimistic for real estate, as the house price index (HPI) is forecasted to increase 21 P a g e

22 modestly over the mortgages expected life. This is in contrast to an incurred loss model with a fairly long emergence period for mortgages. This emergence period includes some very negative periods from the most recent credit crisis, and as a result, the ALLL using the incurred loss model is on the high side of its typical range. Second Lien Residential (HEL, HELOC) ALLL increased by 18.80%, which again was slightly lower than Primatics' expectations, but well within a reasonable range. Similar to first liens, the forecasted credit losses are muted due to the quality of the composition of the hypothetical portfolio and high concentration of recently originated loans. A majority of the new origination are of very good quality with strong equity positions. Also similar to the first liens, the incurred loss model has a longer emergence period and includes negative periods, which results in a higher than average current ALLL. CRE ALLL increased by 25.56%. The analysis on the hypothetical CRE portfolio may have best captured the characteristics of a representative CRE loan portfolio, as Primatics had the strongest benchmarks and leveraged a modeling approach consistent with that of many Primatics customers. The ALLL calculated under the incurred loss model is high by historical standards. If this ALLL was closer to historical norms, the relative increase would be much higher. For example, if the ALLL for CRE loans was 1.50%, the relative increase would be greater than 50%. C&I and Consumer ALLL increased by 20.83% and 46.25% respectively. In addition to the volatility in the ALLL across product types, the analysis highlighted material changes resulting from the different economic scenarios. The Down scenario increased Bank A and Bank B respective Allowances to 2.51% and 2.47%, nearly a 40% increase. Even in the Up scenario, with better than average macro-economic forecast expectations, Bank A and Bank B respected Allowances increased to 2.05% and 2.06%, representing a 15% increase. The study noted that macro-economic and modeling assumptions will have huge impacts on the ALLL under CECL. For purposes of this study, Primatics' analysis leveraged national views on macro-economic assumptions. While attempting to create an 'average' bank, it was noted that geographic factors will significantly influence the expected loss forecast. There have been regional deviations in the past, and the nature of the analysis does not capture those. The analysis assumed that additional draws were not allowed on older lines of credit with signs of credit deterioration. Obviously, enabling continued draw capabilities in a loss model will increase outstanding principal, and thus increase the amount of expected credit loss. This would be magnified for institutions with high concentrations of second lien residential loans. It would be nearly impossible to analyze each of every factor that a bank may choose to consider in a forward looking loss forecast. The lack of prescription of factors to be considered in the expected loss forecast, will be one of the primary challenges in implementing and complying with the guidance, and is likely to lead to increased volatility 22 P a g e

23 as institutions take into consideration widely different factors. With regards to this point, it does seem that the FASB has included the appropriate level of detail in asking institutions to consider future conditions. It is not enough to simply ask these financial institutions to consider future conditions, as it will leave the onus on the investor to determine the impact of each institutions decision to include or exclude certain factors. Additionally, and likely a great challenge for the investors, will be comparing and contrasting what are sure to be a diverse set of factors, and potentially economic forecasts. 23 P a g e

24 3rd Party Service Providers In addition to Primatics' direct data study, I evaluated other industry analyses on CECL's potential range of impact. One study, performed by Milliman in 2013, was particularly insightful in assessing CECLs probable impact on mortgages. As Primatics' analysis noted a relatively small increase for 1st Lien Mortgages (7.33%), Milliman's study demonstrated a more dramatic increase in the reserves in the immediate years following loan originations. The study noted that there is going to be a large capital drain at origination as the book initially builds, since loss estimates must be made for each loan. Eventually, this reserve is released over the life of the portfolio as loans prepay, default, or expire. The Milliman study used a single book of mortgage originations to contrast the existing incurred loss model and the proposed CECL model. To demonstrate the differences in the development of reserves, Milliman extracted loan-level data published by Freddie Mac representing single-family conforming mortgages originated in The study used a simple roll-rate loss model for probable losses on delinquent loans and a small fixed percentage rate of loss for non-delinquent loans. Figure 11: Comparison of CECL to Probable Loss Reserve (Milliman) *Reserve amounts are shown in the exhibit as a percent of the original mortgage amount (basis points). In this example, the 2005 mortgage originations experienced relatively low defaults for the first few quarters after origination as home prices rose and the economy remained healthy, 24 P a g e

25 followed by significant defaults as home prices declined severely over the next couple of years during the credit crisis. The probable loss reserve approach for these originations reflects a lagged pattern to home price movements, which produced a significant amount of strain on the financial sector s capital. Specifically, from late 2007 through late 2009, reserve requirements spiked from approximately 0.40% to over 1.00% of the original loan amounts using our generic assumptions. In contrast, under the CECL model, reserves would have been built-up over the first year as loans were originated and required less of an increase in the reserve requirement as the economy entered a recession (only 0.10% of the original loan amounts). As the CECL model requires more capital at origination of a mortgage to offset estimated future losses, the average return on mortgages for lenders could be negatively impacted as more capital may be required to originate a mortgage compared to the current approach. On the other hand, the volatility of changes in reserves (and therefore earnings) may be reduced as the reserve will reflect a lifetime estimate as opposed to a more reactive measure. 25 P a g e

26 Operational Challenges Summary Financial institutions will face significant challenges implementing and complying with the CECL guidance. The proposed changes will put stress on people, process, and technology; and its impact will span many functional groups across the organization. People Financial institutions should be evaluating current resources and teams supporting the ALLL process, and will should be prepared to hire additional resources. Considerations that will require increased head counts to comply with CECL include education on the final guidance, documentation of new accounting policies and model methodologies, implementation of new controls within the SOX framework, and implementation of technology. Since the allowance will likely be a larger component of the financial statement results, financial institutions will be more reliant than ever on detailed analytics to gain insight into the drivers of assumption changes between periods. Changes in the factors leading to an increase or decrease in the loss expectations and the reason for the change must be disclosed at the portfolio level. Documentation and transparency will be critical in order to adequately support the estimate. Credit quality disclosures are expected to increase significantly under CECL. The American Banking Association noted that, "As vintage analysis may become the basis for credit quality evaluation, disclosures related to credit quality may need to expand to address each critical vintage. This could increase the current GAAP-based disclosures four-fold or more" (ABA pg 6). A manual approach to compiling this information is unlikely to meet the requirements in the time available during the reporting period. In addition to the increased reporting and disclosure requirements, the complexities associated with the proposed standard will require financial institutions to spend more time explaining results to management, auditors, regulators, and investors. Management will need to disclose how it monitors credit quality and how both quantitative and qualitative risks arising from credit quality are addressed. For example, the ASU states that, "an entity shall provide information that enables financial statement users to (1) understand management s method for developing its allowance for expected credit losses, (2) understand the information that management has used in developing its current estimate of expected credit losses, and (3) understand the economic circumstances that caused changes to the allowance for expected credit losses, thereby affecting the related credit loss expense (or reversal) recognized during the period (FASB ASU pg 23)." The new disclosures will require detailed description of the methodology employed, consideration given to past experience, and economic assumptions used. These disclosures will need to 26 P a g e

27 be produced in each reporting period, and support for changes in estimates must be documents. As a result of the new methodology and processes implemented, CECL will draw a high level of scrutiny from auditors and regulators. Internal control requirements will expand and require additional resources to support the requirements. "As with other models used for financial decision-making, a new model used to estimate the ALLL under CECL will be subject to regulatory model risk management standards" (ABA pg. 6). This can be a dynamic exercise and resource intensive, as risk management standards require detailed documentation supporting model validation, and the evaluation of back-testing results. Process As with other major regulatory changes, financial institutions will be required to change their process (e.g., accounting close, reporting close, quarterly close, annual close, SOX processes, business process workflows, technology integrations, etc.). The guidance will further require traditional Risk and Finance groups to collaborate effectively. Both the accounting and credit views will be necessary to determine the method and information used to calculate the reserve. Collaboration between accounting and credit will also be critical to providing a comprehensive explanation of how the current and projected forecasts drive the loss estimates. Changes in credit quality leading to an increase or decrease in the loss expectations must be understood by both accounting and credit. Automation and controls will be essential to information exchange and creating one view of the reserve. In addition to tighter integration between Risk and Finance, financial institutions will have to build out a forward looking reserving process. Institutions will not only have to understand and incorporate historical loss rates into the reserving process, but also include forward looking assumptions in the calculation. Consider the forecast of future economic circumstances; forecasts are highly judgmental, and the potential for expected credit loss volatility is high. These assumptions will need to be developed and supported by a consistent methodology and sound data. Financial institutions will have to substantiate the assumption changes they make over time, and their impacts on the reserve. Technology With CECL on the horizon, technology may pose the biggest challenge for financial institutions. Change has always been a constant in the financial industry but the recent financial crisis triggered an unprecedented rise in that rate of change. As discussed throughout this paper, the CECL guidance is likely to result in increased regulation and will require greater demands for transparency, and the need for tighter integration across finance, risk and technology. It is unlikely that existing systems will be able to accommodate the requirements under CECL. The current set of requirements will stretch system functionality across data 27 P a g e