Agenda. CECL Where are we and how did we get here? What is FASB s Expected Credit Loss Model? Expected Credit Loss Models - Challenges.

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1 The CECL Model

2 Agenda CECL Where are we and how did we get here? What is FASB s Expected Credit Loss Model? Expected Credit Loss Models - Challenges blank 2

3 Background Financial Crisis with credit as a key component Financial Crisis Advisory Group organized by FASB and IASB identified weaknesses Multiple impairment approaches complex and non-intuitive Incurred loss model led to delayed recognition of losses Recommended that the Boards explore alternatives that would use forward-looking information 3

4 History 2010 to mid-2012 FASB and IASB worked together but couldn t agree December 2012 FASB issued CECL exposure draft March 2013 IASB issued exposure draft July 2014 FASB issued CECL exposure draft IASB issued final standard, IFRS 9 August 2015 FASB issued CECL fatal flaw draft September 2015 CECL Transition Resource Group met Q Final CECL Standard Expected 4

5 CECL Model What Is It? CECL is an estimate of current expected credit losses that will be held as an allowance for financial assets measured at amortized cost. FAS 5 FAS 114 SOP 03-3 CECL EITF Replaces FAS 5, FAS 114, and SOP 0-3 for Loans Held for Investment Replaces EITF for Debt Securities Held to Maturity 5

6 CECL Specifics Key Principles Single Accounting Model - applies to all financial instruments measured at amortized cost. Expected Loss Model forward-looking, removes the incurred concept and the probable threshold. Life of Instrument Reserve - requires considering past information, current conditions and reasonable and supportable forecast of future conditions. Not a best estimate - must reflect a risk of loss Time Value of Money - if the estimate is based on a discounted cash flow model, the discount rate used in the model shall be the effective interest rate. 6

7 Comparison to Existing Standards How CECL differs from FAS 5 (ASC 450): The current reserve under FAS 5, is an incurred loss model meaning that an estimate of losses is recognized when it is probable that the loss has already occurred. It is typically expected that the loss will emerge in months. CECL is an expected loss model meaning that an estimate of the life of instrument credit losses will be recognized on all financial instruments measured at amortized cost; there is no probable threshold. How CECL differs from FAS 114 (ASC ): FAS 114 impairment is applied to individual instruments after they are identified as impaired. The estimate is based on the discounted expected cash flows. CECL is similar to FAS 114 in that the reserve is based on life of instrument cash flows. There are questions about whether CECL s reasonable and supportable requirements are implicitly embedded within expected cash flows under the existing FAS 114 DCF calculations. How CECL differs from SOP 03-3 (ASC ): SOP 03-3 as we know it today will no longer exist. Pool accounting is retired. There will no longer be an accretable difference or non-accretable difference. The difference between the UPB and fair value at the time of purchase will be segregated by a credit and non-credit mark. The amortized cost of purchase credit impaired (PCI) instruments will be the purchase price plus the credit mark (expected credit loss at acquisition). The difference between the amortized cost and the UPB (non-credit mark) is amortized or accreted into income. Interest income (if not in non-accrual) will be recognized based on the amortized cost and the remaining contractual cash flows. 7

8 CECL Model Developing an Allowance Estimate Required to evaluate assets on a collective basis where similar risk characteristics exist Consider all contractual cash flows Including expected prepayments Excluding extensions, renewals, and modifications unless a TDR is expected Consider past events, current conditions, and reasonable and supportable forecasts Includes qualitative and quantitative factors and relevant internal and external information Always reflect the risk of loss, even when remote; however, will not be required to recognize a loss when the risk of nonpayment is greater than zero yet the amount of loss would be zero Revert to historical average loss experiences for future periods beyond which the entity is able to make or obtain reasonable and supportable forecasts 8

9 Challenges Regulators and auditors Data Modeling and forecasting future Process and controls Auditability (lot of judgment) Disclosures 9

10 Do s Ahead of CECL Understand the new CECL requirements Take time to read the proposal, really understand it. Talk to people about implementation. Compile as much loss data as you can, in as much detail as you can, as far back as you can Collect as much data on losses (charge-offs net of recoveries) for as many loan types and loan risk rating buckets as possible, and in as much granular detail as possible. Banks should be taking steps right now to gather the information. Think carefully about the correlation of losses to general economic data, specific risks, etc Creation of a forward-looking model for an ongoing material accounting process requires forethought. 10

11 Don ts Ahead of CECL Don t panic! Take time to read the proposal, really understand it. Talk to people about implementation. No early incorporation of expected loss concepts Some may want to incorporate the new model into their existing model now in order to avoid volatility in the ALLL that may exist under the new model. Keep in mind that you are not permitted to incorporate the new model prior to its implementation date. Do not overload at adoption Creating cookie jar reserves at adoption/transition should be avoided. 11