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1 Short, engaging headline To discount or not to discount, a CECL strategic decision kpmg.com

2 Introduction As banks enter the design and implementation planning phases for ASU , Measurement of Credit Losses on Financial Instruments, commonly known as CECL (Current Expected Credit Losses), entities are realizing the magnitude of the impact this accounting change has on their current allowance accounting processes, models, and data. As with any accounting change, organizations of all sizes will need to go through a conversion cycle that involves assessing the current state against the target state, identifying gaps, designing a road map to bridge these gaps, and implementing the target design conversion into a business-as-usual state that will be operational and sustainable without additional undue burden. Entities manage credit risk differently, and, as a result, the FASB provides flexibility in measuring expected credit losses under CECL based on various factors. Entities management teams will be required to make and support several decisions on key aspects of their CECL implementation, including modeling methodology, data sourcing and usage, length of reasonable and supportable forecast periods, historical reversion approaches, internal controls, and whether to use discounted cash flows, among other critical decision points. In this paper, we will focus on exploring the use of the discounted cash flow method as part of the measurement and recognition of the CECL amount. CECL does not prescribe the use of a specific loss methodology, but rather provides entities with the flexibility to utilize existing or new loss estimation methodologies based upon management s determination of the best approach for any particular segment of the portfolio. In addition, CECL provides the option to utilize a discounted cash flow (DCF) approach. Although DCF is not a CECL loss projection methodology itself, it is listed in the standard as one of the options companies may implement to estimate CECL amounts. In order to project cash flows, DCF requires inputs quantifying loss or default rates from another loss projection methodology in addition to the financial instrument contractual terms and prepayment projections. After the cash flows are projected, they are discounted at the financial instrument s effective interest rate (EIR), and the allowance for credit losses is calculated as the difference between the amortized cost basis and the present value of the expected cash flows. An entity may elect to utilize DCF for certain pools of financial assets with similar risk characteristics while not using DCF for other pools. Entities may consider several factors including time value of money, exposure at default amounts, consistency with fair value concepts, allowance level and volatility, operational consistency, impact of premiums, discounts, fees, and costs on the allowance amount, and internal controls over financial reporting.

3 Time value of money The EIR is the rate of return implicit in the financial asset that is, the contractual interest rate adjusted for any net deferred fees or costs, premium, or discount existing at the origination or acquisition of the asset. The asset s EIR, which is used to recognize interest income, provides useful information about the level of credit risk a lender took on when it originated or purchased a financial asset. For example, an originated loan coupon includes the credit risk spread the originating entity required to compensate for the borrower s credit risk. As such, the use of a DCF with the EIR as a discount rate aligns the concepts of timing of losses with income recognition. Expected losses of financial assets may vary over the projection horizon, creating a challenge to quantify the effect of timing of a loss event. In essence, the further into the future a loss is projected, the smaller the impact on the present value of the asset due to the longer discounting period. This leads to a lower allowance associated with the projected loss event. In other words, the DCF approach results in a CECL allowance estimate that is consistent with the amortized cost basis of a financial asset that implicitly reflects the time value of money. Non- DCF loss projection methodologies do not typically align the income recognition with the expected timing of losses. In addition, because DCF utilizes the asset s EIR, the impact of losses on the premiums, discounts, fees, or costs is implicit in the CECL amount. Other loss methodologies typically consider the financial assets unpaid balance as a basis for estimating losses against. As such, entities may have to account for the impact of the losses on other elements of the cost basis separately. To discount or not to discount, a CECL strategic decision 3

4 Exposure at Default (EAD) Estimating the financial assets expected losses over the remaining life of the asset is highly dependent on the expected outstanding balance at each hypothetical loss date. The asset balance in turn is driven by the contractual cash flows as well as prepayments (voluntary and involuntary). The use of DCF provides an explicit projection of balance and hence exposure at default (EAD), factoring in both the contractual terms as well as prepayment assumptions. In comparison, some other loss methods detailed in the standard and used by market participants do not provide the explicit considerations for instrument contractual terms and prepayments. Consistency with fair value concepts Valuing less liquid financial assets by applying the income approach involves a discounted cash flow method. Utilizing a combination of a loss method to project periodic loss rates and DCF method to apply those rates to the expected cash flows is consistent with the fair value concept when the income approach is used. Many less liquid assets, such as loans, are measured at fair value using the income approach. In fact, the present value calculations are consistent with the instrument fair value concept at either origination or purchase, as the EIR is calculated based on the purchase price (representing fair value) or origination amortized cost. As such, a CECL DCF approach would provide the opportunity to periodically benchmark the assumptions against fair value by applying a market-based discount rate as a parallel analysis. In addition, entities are required to disclose the fair value of their amortized cost assets and could use the same CECL DCF models while applying a market discount rate instead of the EIR. This would help entities prevent duplicating the effort to calculate fair value separately. It would also support consistency of loss projections for the same assets across different purposes. These benefits would be recognized by entities implementing a CECL DCF approach, while other loss methodologies may not provide such benefits.

5 Allowance level and volatility Because CECL DCFs are discounted at the asset s EIR, the resulting CECL allowance amount, in many cases, will be lower than the nondiscounted amount. In addition, the use of DCF may reduce volatility in the allowance for credit losses, as tail risks and changes in more distant future losses, which are inherently more difficult to forecast with precision, would have a lower impact on the overall allowance. Conversely, the closer and more certain loss amounts would have a greater weight in the overall allowance estimate. As such, the DCF approach may be more reflective of the true economics of the time value of money, reduce volatility by placing comparatively more weight on more predictably quantifiable near-term losses and reduce the impact of estimation errors later in the life of assets. Internal controls over financial reporting Internal controls over financial reporting (ICOFR) are a key factor to consider in developing the CECL process. Many current loss estimation models and processes (e.g., DFAST / CCAR models) reside outside of the financial reporting realm and, as such, do not go through the rigor of financial reporting governance and may require enhancements. Utilizing DCF could provide an added layer that can help to monitor changes in periodic loss projections and attribute them to specific factors. Auditors and regulators are used to DCF monitoring methods, including back-testing of assumptions and periodic cash flows. To discount or not to discount, a CECL strategic decision 5

6 Operational burden Because utilizing a DCF approach creates an additional layer of calculations, it adds some operational burden due to increased process complexity and maintenance of the additional layer. ICOFR over the DCF models and systems may also add incremental complexity. The use of the asset s EIR may reduce the operational challenges encountered with prior accounting requirements, such as for Purchased Credit Impaired (PCI) loans. In addition, the allowance will not be required to be rolled forward by accreting or amortizing it, but rather the difference between the prior discounted allowance and the current discounted allowance will be recognized as income or loss, a straightforward calculation relative to prior PCI accounting requirements. It is unclear yet if the EIR used over time is the initial EIR or the EIR as it changes from period to period based on the premium or discount amortization calculations. Conclusion The arrival of the CECL standard is an opportunity for entities to strategically plan the Allowance for Credit Losses process as a coordinated effort between finance, loan operations, information technology, front office, and credit risk. Entities may carefully prioritize the important goals of the organization such as lower allowance volatility, accurate allowance level, easier auditability, process automation, integration within other financial estimates, allowance consistency over time, and reduced need for qualitative adjustment against the level of initial investment required and process sustainability. For many entities, achieving the former goals may require higher initial investment, but could potentially reduce allowance and earnings volatility and capital charges, and save significant future costs, while adding value to the organization in the long run.

7 About KPMG KPMG is a leader in providing financial, risk management, and accounting services to the financial services industry. We serve 75 percent of the top 100 U.S. financial institutions and have a deep understanding of business operations and accounting considerations related to credit loss estimates. Many of our Banking & Finance partners and professionals have worked in the industry they now serve. That means we bring in-depth knowledge and understanding of the issues, enhanced by technical know-how and a tested track record of proactive client service. As part of a global network of member firms, KPMG has also been at the forefront of IFRS 9 implementations, helping numerous financial intuitions across the globe to overcome the challenges of lifetime expected credit losses. Additionally, our development of the gclas tool provides insight into managing the many factors that must be included and coordinated in an effective CECL credit loss model. To discount or not to discount, a CECL strategic decision 7

8 Contact us Ed Bayer CECL Transition Leader, Credit Risk Advisory T: E: Mike Ohlweiler A.L.L.L. Group Leader T: E: Yuval Ron Director, Financial Risk Management T: E: Reza van Roosmalen Financial Instruments, Accounting Change Leader T: E: Anthony Sepci Partner, Data and Analytics T: E: Some or all of the services described herein may not be permissible for KPMG audit clients and their affiliates. kpmg.com/socialmedia The KPMG name and logo are registered trademarks or trademarks of KPMG International. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. The KPMG name and logo are registered trademarks or trademarks of KPMG International. NDPPS