FASB s CECL Model: Navigating the Changes

FASB s CECL Model: Navigating the Changes Planning for Current Expected Credit Losses (CECL) By R. Chad Kellar, CPA, and Matthew A. Schell, CPA, CFA Audit Tax Advisory Risk Performance 1

Crowe Horwath LLP The final deliberations by the Financial Accounting Standards Board (FASB) on its project related to the impairment of financial instruments 1 are drawing to a close, and the board is expected to issue a final standard in 2015. Of course, prior to deciding to issue a final standard, the board members, as a matter of due process, will ask themselves whether re-exposure is warranted. While the deliberations are not yet complete and the wording from the proposal will be tweaked, the CECL model, which was proposed 2 in December 2012, will remove the probable threshold that exists today and requires the development of an estimate of all contractual cash flows not expected to be collected. 3 Given the pervasive impact of the CECL model, many financial institutions are beginning to think about the impact the new model is likely to have on their allowance methodologies. 1 FASB, Accounting for Financial Instruments Credit Impairment, a joint project of the FASB and International Accounting Standards Board, http://www.fasb.org/jsp/fasb/fasbcontent_c/projectupdatepage&cid=1176159268094 2 For background about the project, see Sydney Garmong, Is the Third Time the Charm? The FASB Proposes Major Changes for Credit Losses, Crowe Horwath LLP, January 2013, http:///contentdetails.aspx?id=5611 3 Sept. 17, 2013, joint board meeting minutes, Accounting for Financial Instruments: Impairment, http://www.fasb.org/cs/contentserver?c=document_c&pagename=fasb/document_c/documentpage&cid=1176163467502 2

FASB s CECL Model: Navigating the Changes Table of Contents Evaluate the Scope...4 Develop an Estimate of Expected Credit Losses for the CECL Model...5 Inputs (Expected Credit Loss Drivers and Expected Life)... 5 Unit of Account... 6 Probability or Path... 7 Examine Methodologies Commonly Used Today...8 Discounted Cash Flow Analysis... 8 Average Charge-Off Method... 9 Vintage Analysis... 9 Static Pool Analysis...10 Roll-Rate Method (Migration Analysis)...10 Probability-of-Default Method...11 Regression Analysis...11 Some Considerations for How Current Methodologies Will Change Under the CECL Model...12 Discounted Cash Flow Analysis...12 Average Charge-Off Method...12 Vintage Analysis...13 Static Pool Analysis...13 Roll-Rate Method (Migration Analysis)...13 Probability-of-Default Method...14 Regression Analysis...14 Conclusion...14 3

Crowe Horwath LLP The new standard is expected to be flexible enough to allow financial institutions to use different methodologies to determine their allowance. One possibility that is being discussed in practice is that the implementation of the CECL model could be achieved by incorporating existing risk management practices into the allowance methodology, which would provide entities with a starting foundation. The first thing management must do is evaluate the current data and methodologies to determine what new information will need to be acquired and what changes will have to be instituted to transition to the CECL model. To understand what changes a financial institution might need to make, it is important to consider a few factors: What instruments will be included in the scope of the new CECL model? How will expected credit losses be evaluated? What methodologies will be allowed? What changes to the current methodology and available data will be necessary? The first thing management must do is evaluate the current data and methodologies to determine what new information will need to be acquired and what changes will have to be instituted to transition to the CECL model. Evaluate the Scope The FASB concluded during its re-deliberations that entities will apply the CECL model to financial assets measured at amortized cost. 4 Financial assets measured at amortized cost for a typical financial institution include more than just loans; they will include other financial assets such as debt securities that are classified as held to maturity (HTM). Certain types of financial assets measured at amortized cost, such as related party loans and receivables between entities under common control, will be excluded from the scope of the CECL model. 5 In addition, the FASB has discussed that entities will need to evaluate expected credit losses on other types of instruments including (1) loan commitments that are not classified at fair value through net income, (2) financial guarantee contracts not accounting for as insurance or at fair value through net income, (3) reinsurance receivables, and (4) lease receivables. 6 Debt securities that are classified as available for sale (AFS) will be excluded from the CECL model. The accounting for impairment of AFS debt securities will follow a new modified impairment process that is a combination of the current other-than-temporary impairment (OTTI) approach in FASB Accounting Standards Codification (ASC) 320 7 and the new CECL model. The new modified impairment approach no longer will require an entity to consider the length of time that the fair value of the security has been below amortized cost; this requirement has been part of the current OTTI analysis. In addition, entities will record an allowance for expected credit losses, rather than a direct write-down, on AFS debt securities that can be reversed immediately in the period of recovery in expected cash flows. However, an allowance for an AFS security would not be recorded if the financial asset s fair value equals or exceeds its amortized cost basis. 8 4 March 12, 2014, board meeting minutes, Accounting for Financial Instruments: Impairment, http://www.fasb.org/cs/contentserver?c=document_c&pagename=fasb%2fdocument_c%2fdocumentpage&cid=1176163908510 5 Oct. 29, 2014, board meeting minutes, Accounting for Financial Instruments: Impairment, http://www.fasb.org/cs/contentserver?c=document_c&pagename=fasb%2fdocument_c%2fdocumentpage&cid=1176164536964 6 Ibid. 7 FASB ASC 320-10-35, Investments Debt and Equity Securities Overall Subsequent Measurement. 8 March 12, 2014, board meeting minutes, Accounting for Financial Instruments: Impairment, http://www.fasb.org/cs/contentserver?c=document_c&pagename=fasb%2fdocument_c%2fdocumentpage&cid=1176163908510 4

FASB s CECL Model: Navigating the Changes Equity securities, also excluded from the scope of the CECL model, will be accounted for either at fair value with changes recognized in net income or under other appropriate accounting (the equity method or the practical expedient for equities without a readily determinable fair value, for example). Crowe Observations: Including HTM debt securities in the CECL model will result in a change in practice. Previously these securities had been evaluated using the OTTI model. The change for all HTM or AFS debt securities to use an allowance, rather than recording a direct write-down (basis adjustment), is positive. By using an allowance, improvement in credit may be recognized immediately. Purchased credit-impaired (PCI) financial assets and certain beneficial interests in securitized financial assets, if measured at amortized cost, will record an allowance for expected credit losses under the CECL model upon acquisition (which is a change from current practice) and in subsequent periods. (Note that the FASB plans to simplify the current PCI model by recording the face (par) amount, allowance, and noncredit discount such that current loan subledgers may be used. 9 ) Some types of securities that are PCI or beneficial interests in securitized financial assets that would have historically qualified to be accounted for as AFS will not be accounted for under the CECL model because they are not measured at amortized cost. At this juncture, the board has not published tentative decisions on how to handle these types of instruments. Develop an Estimate of Expected Credit Losses for the CECL Model When determining how expected credit losses will be evaluated and estimated, entities should examine several factors, including inputs, unit of account, and probability or path. Inputs (Expected Credit Loss Drivers and Expected Life) For financial assets measured at amortized cost, a current estimate of all contractual cash flows not expected to be collected should be recorded as an allowance for expected credit losses. Entities should consider past events, current conditions, and reasonable and supportable forecasts when developing their estimate of contractual cash flows over the life of a related financial asset. Entities also should consider relevant quantitative and qualitative factors that exist in their business environment and similar factors that relate to their borrowers (underwriting standards, for example). 10 Entities will need to determine estimates of the expected life of a financial asset by considering expected prepayments but not considering expected extensions, renewals, or modifications unless the entities anticipate executing a troubled debt restructuring with the borrower. The process for determining the expected life of a loan commitment not measured at fair value through net income depends on the type of loan commitment (funded versus unfunded). For funded loan commitments, the FASB board decided that expected credit losses should be estimated similar to other loans. That would require entities to consider cash flows over the expected life including prepayments but excluding extensions, renewals, or modifications unless the entity anticipates it will execute a troubled debt restructuring. For unfunded loan commitments, the FASB board decided that the expected credit losses for unfunded loan commitments that are not unconditionally cancelable should reflect the full contractual period of the commitment. 11 9 Feb. 19, 2014, board meeting minutes, Accounting for Financial Instruments: Impairment, http://www.fasb.org/cs/contentserver?c=document_c&pagename=fasb%2fdocument_c%2fdocumentpage&cid=1176163851560 10 Oct. 29, 2014, board meeting minutes, Accounting for Financial Instruments: Impairment, http://www.fasb.org/cs/contentserver?c=document_c&pagename=fasb%2fdocument_c%2fdocumentpage&cid=1176164536964 11 Sept. 3, 2014, board meeting minutes, Accounting for Financial Instruments: Impairment, http://www.fasb.org/cs/contentserver?c=document_c&pagename=fasb%2fdocument_c%2fdocumentpage&cid=1176164388432 5

Crowe Horwath LLP Crowe Observations: The shift from the incurred loss model, which required a loss to be probable before it was recognized, to the CECL model, which represents all contractual cash flows not expected to be collected will be a significant change that will require alterations to an entity s allowance methodologies and data needs. The quantitative and qualitative factors already noted could be from either internally or externally available sources. With the change to an expected loss model, considering prepayments for the expected life of longer-term financial assets, such as 30-year mortgages, can be important depending on how the allowance methodology functions. Consideration of some of the OTTI criteria for HTM securities will no longer be required. However, the evaluations of expected credit losses for some debt securities, such as residential mortgage-backed securities (RMBS), are likely to be similar to those previously used in practice with the exception of the potential for required pooling of HTM debt securities. In current practice, entities evaluating OTTI often model both HTM and AFS RMBS debt securities based on available internal and external statistics for similar instruments. Historically, existing U.S. generally accepted accounting principles (GAAP) and regulatory guidance have not addressed payment turnover for lines of credit and credit card loans (that is, if the average life is determined based on gross payments or net payments). The FASB concluded in its re-deliberations that loan commitments will be addressed in the CECL model, with the funded portion being similar to existing loans. If unfunded commitments cannot be unconditionally canceled by the lender, expected credit losses will reflect the full contractual period. It remains to be seen if the FASB will provide an illustration of the mechanics or further discussion in the basis for conclusions. Unit of Account In its re-deliberations, the FASB concluded that entities will be required to evaluate expected credit losses on financial assets on a pool basis if the assets share similar risk characteristics and are measured at amortized cost. At times, an institution might not have multiple assets with similar risk characteristics; in that case, it would then evaluate those financial assets on an individual basis. The evaluation of individual financial assets under the CECL model should consider relevant internal information and should not ignore relevant external information 12 (for example, credit ratings and credit loss information for financial assets of similar credit quality). Crowe Observations: For financial assets evaluated on an individual basis, the removal of the best estimate notion and the inclusion of relevant internal and external information are likely to encourage institutions to consider, based on expectations of losses for pools of similar assets that might be externally available, the possibility of expected losses on that individual asset. Said another way, where a previous conclusion might have resulted in the best estimate of a zero loss on an individually evaluated loan, a different answer might result when considering the available external information indicating that a probability of a loss exists. The requirement to measure impairment under the CECL model first by pooling financial assets with similar risk characteristics would apply to all financial assets that are in scope generally, financial assets measured at amortized cost. Accordingly, HTM securities that are measured at amortized cost will be in scope and be required to be measured for impairment in a pool with securities that share similar risk characteristics which would be a change from current practice. 12 Accounting for Financial Instruments: Impairment Tentative Board Decisions to Date During Redeliberations as of Oct. 29, 2014, http://www.fasb.org/cs/contentserver?c=document_c&pagename=fasb%2fdocument_c%2fdocumentpage&cid=1176163819556 6

FASB s CECL Model: Navigating the Changes Probability or Path In its re-deliberations, the FASB concluded that entities should always reflect the risk of loss, even when that risk of loss is remote. However, entities would not be required to recognize a loss in the event that there is a probability of default but the amount of the loss severity would be zero (that is, there is adequate collateral in the event of default). In other words, if the amount of collateral is such that no loss would be recognized in the event of default, a loss need not be recognized. Entities will need to develop an estimate of the expected credit losses, and one method might include starting with the historical losses and then adjusting for differences based on current conditions and reasonable and supportable forecasts. However, the FASB clarified that entities will not be required to forecast conditions and make related adjustments to the historical loss patterns for the expected life of the financial asset; instead an entity should revert to unadjusted historical credit loss experience for future periods beyond which the entity is able to make or obtain reasonable and supportable forecasts. 13 Commonly, this is referred to as reversion to the mean. Reversion to the mean or mean reversion is a mathematical theory often used in various financial applications such as stock investing. In simple terms, a variable is mean reverting if over time it tends to return to a particular level following periods of increases (or decreases) above (or below) that level. The FASB provided two alternatives to accomplish reversion to the mean: (1) by reverting over the financial asset s estimated life on a straight-line basis or (2) by reverting over a period and in a pattern that reflects the entity s assumptions about expected credit losses over that period. As an example, assume that an entity has a 30-year residential mortgage with an estimated life of seven years. Management can reasonably estimate expected credit losses for the next two years, but after that, management does not have reasonable and supportable forecasts to determine expected credit losses. One option to establish expected credit losses in the final five years would be to revert on a straight-line basis to the unadjusted average credit losses for the remaining period. In this example, if expected losses over the next two years are 10 basis points (bps) and the unadjusted historical loss experience is 15 bps, the straight-line reversion would be as follows: Year 1 2 3 4 5 6 7 Expected Losses 10 bps 10 bps 11 bps 12 bps 13 bps 14 bps 15 bps Crowe Observations: The FASB s characterization of risk of loss establishes a high hurdle for not recording an expected credit loss. Institutions will be required to consider the likelihood of nonpayment or a loss based on all available information, but information indicating a probability of default may be offset by the impact of collateral and other available sources of repayment. Entities will be expected to make projections about the expected losses as far as they can reasonably estimate into the future. The FASB has provided a practical expedient by allowing entities to assume that over the remaining term of the financial asset, expected credit losses should return to their unadjusted average historical credit losses. Entities will have an option to select either pattern of reversion, which would need to be disclosed. Changes in the reversion period would represent a change in estimate rather than a change in accounting policy. (A change in accounting policy would require the change to be preferable.) 14 13 Accounting For Financial Instruments: Impairment Tentative Board Decisions to Date During Redeliberations as of Oct. 29, 2014, http://www.fasb.org/cs/contentserver?c=document_c&pagename=fasb%2fdocument_c%2fdocumentpage&cid=1176163819556 14 FASB ASC 250-10-45, Change in Accounting Principle. 7

Crowe Horwath LLP Examine Methodologies Commonly Used Today Providing flexibility, the FASB concluded that there will not be restrictions on the types of methodologies used to develop an estimate of expected credit losses. Specifically, it said that entities will not be prohibited from using discounted cash flow, lossrate, probability-of-default, or provision matrix models when developing their estimates. Many models currently used by financial institutions would fit into one of these categories and be capable of assisting in the development of an expected credit loss estimate. At times, different models are used on different asset types, or combined to use on one asset type, to develop an estimate of credit losses. Examples of some models used in practice today include: Discounted cash flow analysis Average charge-off method Vintage analysis Static pool analysis Roll-rate method (migration analysis) Probability-of-default method Regression analysis Average charge-off, vintage, and static pool analysis are examples of loss rate methods, while regression analysis may be used to establish relationships in historical data that can assist in projecting losses within various acceptable methodologies. Following is some background on how each of these examples is used today in the incurred-loss model for the allowance for loan losses. Discounted Cash Flow Analysis As described in ASC 310-10-35, 15 a discounted cash flow analysis is based on the present value of expected future cash flows discounted at the loan s effective interest rate. This type of analysis is one of the currently prescribed methods for measuring impairment on an individual impaired loan. (Alternatives include the practical expedient of applying the collateral-dependent method or the observable market price approach.) Expected cash flow assumptions used in the discounted cash flow analysis are based on an institution s best estimate of reasonable and supportable assumptions and projections. Crowe Observation: Although the collateral-dependent method is not within the scope of this article, it is worth mentioning here that the FASB plans to change the definition of collateral-dependent, which may have an effect on when the application of this method is appropriate. Providing flexibility, the FASB concluded that there will not be restrictions on the types of methodologies used to develop an estimate of expected credit losses. 15 FASB ASC 310-10-35, Receivables Overall Subsequent Measurement. 8

FASB s CECL Model: Navigating the Changes Average Charge-Off Method The average charge-off method is generally the most commonly used approach for evaluating impairment on pools of financial assets and is fairly straightforward relative to many other approaches. This method calculates an estimate of losses primarily based on past experience. Generally, an institution starts by dividing the financial asset portfolio into segments and then determines a historical look-back period (which, depending on the asset class, could be a number of months or a number of years) that is long enough to develop an accurate estimate of incurred losses for the segment. Next, the institution calculates an average charge-off ratio for each segment and makes necessary adjustments to that historical average charge-off ratio to reflect the impact of differences in various quantitative or qualitative factors. In addition, institutions often weight the data in the look-back periods in an effort to develop an appropriate estimate of probable incurred losses that exist at the point of measurement. Depending on the portfolio, segmentation can be achieved in many ways by identifying similar risk characteristics (for example, financial asset type, collateral type, size, credit score, geography), and the data needs of this method are modest compared to those of other methods. Vintage Analysis Vintage analysis measures impairment based on the age of the accounts and the historical asset performance of assets with similar risk characteristics. This methodology works well with types of financial assets that follow patterns or loss curves that are comparable and predictive for subsequent generations of financial assets (indirect auto loans, for example). First, an entity determines an appropriate type of financial assets that share similar risk characteristics, and then the entity develops a cumulative loss curve for the applicable financial assets based on historical data. It is common for different vintages to be analyzed by year of origination, assuming the pool of loans is homogenous. For vintage analysis, adjustments may be made for differences in quantitative or qualitative factors from period to period, but generally the financial asset would be assigned a loss factor based on the point on the loss curve that correlates to the financial asset s age. For example, a pool of similar five-year financial assets might show loss experience as follows: Loss Experience by Year Following Origination Year 1 Year 2 Year 3 Year 4 Year 5 0.25% 0.50% 1.00% 0.75% 0.00% Typically, the incurred losses for a pool of assets in year three would be 1 percent. However, based on the historical loss experience shown in the table, the total expected losses for the life of the pool of assets would be 2.5 percent, which is the accumulation of the five-year loss experience. When such loss curves (which are used to generate loss estimates based on the age or seasoning of the loan portfolio) are further broken down into year of origination, the loss rates are more granular and lend themselves easily to regression analysis in order to establish relationships between loan underwriting (such as credit score or loan-to-value ratio) and economic variables (such as unemployment and housing price index for mortgage loans). This makes it easier to track if, for example, loans originated five years ago have had a very different first-year loss experience compared to loans originated last year. 9

Crowe Horwath LLP Static Pool Analysis Vintage analysis and static pool analysis are commonly interchangeable terms; however, static pool simply means segmenting and tracking assets over a period of time based on similar risk characteristics. In practice, the main difference between vintage and static pool analysis is that vintage analysis is based on the year of origination and/or the age of the asset while static pool analysis is based on a type of shared pooling criterion and assets originated in a similar time period. Static pools often are formulated by aligning common risk characteristics within existing segments or classes (cohorts) of loans. Static pools often are segmented by similar risk characteristics such as collateral type, loan structure, credit risk indicators such as risk rating or consumer credit scores, and loan-to-value ratio for assets originated in the same period. Commonly used to track loss rates, static pools also can be used to track other assumptions affecting credit loss and timing assumptions about prepayment rates, cumulative default probabilities and default curves, and loss severity, for example. Thus, static pools often are used to support many components of the various acceptable methodologies. The main difference between vintage and static pool analysis is that vintage analysis is based on the year of origination or the age of the asset while static pool analysis is based on a type of shared pooling criterion and assets originated in a similar time period. Roll-Rate Method (Migration Analysis) The roll-rate method is often referred to as migration analysis or flow model and is based on determining a prediction of credit losses based on segmentation (by delinquency or risk rating, for example) of a portfolio of financial assets. No standard roll-rate model is used throughout the financial institutions industry, but most of the models used are based on similar underlying principles. For example, the portfolio could be divided into different risk ratings. Once segmented, the percentages of assets that will roll or migrate to a more severe risk rating are measured and are referred to as roll rates. Financial institutions might incorporate an averaging technique over time in order to develop an average roll rate for each segment that could be adjusted for quantitative or qualitative factors. After the roll rate is determined for each segment, each respective roll-rate percentage is applied to the balance in each category to arrive at an estimate of the amount that will migrate to the next category. The total migration for each category is aggregated to determine the allowance. 10

FASB s CECL Model: Navigating the Changes Probability-of-Default Method The probability-of-default method is used to estimate credit losses by considering three components: (1) probability of default, (2) exposure at default, and (3) loss given default. The method is also used by many risk management systems and within the Basel II and Basel III frameworks. The three components generally are defined as follows: 1. Probability of default (PD) Probability of default over a given time period 2. Exposure at default (EAD) Balance of the relationship at default 3. Loss given default (LGD) Ratio of loss relative to the EAD at default In this simple illustration, assuming none of the three components is correlated with any other component, expected credit losses would be expressed by the following equation: Credit losses = PD EAD LGD First, a financial institution must segment its portfolio by risk characteristics and develop estimates of these three components based on uniform definitions of default and loss. The development of each estimate generally is completed as follows: PD could be a simple average, externally acquired and mapped to the specific segments analyzed, or it could be based on various default probability models on a by-borrower or by-dollar basis. EAD could be the balance of the financial asset today or a higher or lower balance depending on the type of product (amortizing, nonamortizing, or revolving). LGD similar to PD could be a simple average, externally acquired, or based on models. After the portfolio is segmented and these factors are developed, further adjustments can be made based on correlations that might exist among the factors. While beyond the scope of this paper, one consideration for a probability-of-default model is the impact of correlation between the components. For example, during a recession it is common for probability of default to rise and loss given default also to rise. An entity should consider appropriate adjustments for the correlation of these components to avoid misstating the amount of credit loss. Regression Analysis Regression analysis uses economic data such as unemployment rates, bankruptcy rates, and the consumer debt-to-income ratio to estimate a relationship between this data and losses in a portfolio. Essentially, an institution uses statistics to determine an estimate of credit losses (the dependent variable) based on one or multiple inputs (independent variables). Because of the complexity of the models, the data requirements, and the need for highly trained personnel, regression analysis is not widely used in practice, but it is used at times in combination with some of the other methodologies. 11

Crowe Horwath LLP Some Considerations for How Current Methodologies Will Change Under the CECL Model Regardless of how allowance amounts are calculated, generally the CECL model will incorporate one significant change based on the previously discussed methodologies. Specifically, the CECL model will require a change to the allowance methodology from today s incurred loss model to an expected credit loss model, which is a lifetime estimate. Because of that fundamental change, institutions will have to develop estimates that are clearly more forward-looking than they were in the past. Institutions will have to change their methodology (by either modifying their existing methodology or making a wholesale change in methodology) to implement the CECL model. However, the models do not need to be unnecessarily complex, and only relevant factors to the underlying financial assets should be used. Entities might need to re-evaluate the current primary drivers of loss when revising their methodologies. While it s likely more than one driver of expected losses exists for each portfolio, factors that do not demonstrate a correlation with expected losses should not be incorporated. While institutions may use existing risk management practices or systems to develop this forward-looking estimate, many of those systems may not have been subjected to financial statement and internal control audits, and entities should consider this as they develop a plan to implement the CECL model. Fundamentally, entities will see changes in the data needed to implement the CECL model. For example, entities might need to develop and construct loan pools to analyze historical performance. These loan pools likely will need to include longer look-back periods and new data to enable the analysis of new factors such as prepayments. Changes in the methodologies implemented or the risk characteristics used to organize the portfolio also could require new data to be historically gathered as well as prospectively tracked (examples include credit scores or other underwriting criteria). Discounted Cash Flow Analysis Discounted cash flow methods are expected to change under the CECL model due to the removal of the best estimate notion and a requirement to consider at least some risk of loss. Accordingly, new data might have to be developed or obtained to support the cash flow expectations, especially for individual assets, given that analysis cannot ignore relevant external information such as credit ratings and credit loss information for financial assets of similar credit quality that may indicate an expected credit loss. 16 Average Charge-Off Method Historically, average charge-off methods have incorporated a look-back period during which an average charge-off percentage is developed. One consideration when applying the CECL model will be changing from what frequently was an annual average charge-off rate to a lifetime charge-off rate. The FASB s 2012 exposure draft did not allow simple multiplication of the average annualized charge-off factor for the expected life of the asset when developing an expected loss estimate, so a different analysis might be required. Options for deriving the expected credit losses might include static pool analysis or the application of dynamic annual charge-off rates in conjunction with dynamic annualized prepayment expectations (in other words, vectored assumptions that change over time in response to factors that have an impact on those assumptions) to a pool of financial assets for the remainder of their life. Dynamic assumptions are typically used today in modeling RMBS OTTI and are generally supported by current pool performance and historical vintage analysis. 16 Accounting For Financial Instruments: Impairment Tentative Board Decisions to Date During Redeliberations as of Oct. 29, 2014, http://www.fasb.org/cs/contentserver?c=document_c&pagename=fasb%2fdocument_c%2fdocumentpage&cid=1176163819556 12

FASB s CECL Model: Navigating the Changes One additional consideration for average charge-off methods is that the base percentage is grounded in historical data, but average charge-off methods frequently require that subjective adjustments be made to reflect changes. Typically, these adjustments consist of one aggregated adjustment supported by several factors that are often difficult to quantify and support. Our expectation is that qualitative adjustments to average charge-off models will continue under the CECL model. Some of the other methodologies (such as probability-of-default methods) incorporate individual subjective adjustments that can be supported at the factor level (such as prepayment speeds or collateral value changes) and derive changes in estimates accordingly. Vintage Analysis Vintage analysis is based on loss curves that include expectations of losses at each point in the life of a financial asset. Accordingly, the main change to this method under the CECL model is that the allowance will no longer be reflected by a point on the loss curve; rather, it will be reflected by the remaining area under the loss curve (that is, the expected credit losses on the remaining life of the asset). Static Pool Analysis It is important to understand that whatever methodology is used to forecast expected losses, a baseline expectation of portfolio performance based on history will need to be established. Institutions likely will resort to use of a static pool concept, also referred to as a cohort. Static pools generally are formulated by aligning common risk characteristics within existing segments or classes of loans. Establishing static pools based on origination dates (same month, quarter, or year) will allow institutions to track life-to-date loss rates and other performance characteristics that, as tracked over the life of the loans, will generate a baseline for lifetime of loss estimates. Institutions will need to assess their ability to perform this type of analysis looking back over several years of origination and collection data for the initial implementation of the CECL model. Roll-Rate Method (Migration Analysis) With the roll-rate method, a financial institution will need to assess the primary attributes that most appropriately predict loss and take into account significant historical data sets. For example, some institutions might believe that implementing a CECL roll-rate method based on risk rating will be the most predictive of expected losses. However, analysis of various data sets is needed before the final assessment can be made about what might be most predictive. Often roll-rate models based on risk ratings are not the best predictive measure because they require regular and timely updates to credit risk ratings for all assets. Default or loss migrations should be assembled to reflect various economic cycles and tested through those cycles to assess the reliability of the model. Limitations on time series length, data integrity, and population sizes may need to be supplemented with judgments and further calibrated over time to improve precision. Ultimately, it will take time for an institution to make these final determinations before deciding to implement such a methodology. 13

Crowe Horwath LLP Probability-of-Default Method In order to develop a model driven by the probability-of-default method, the institution must consider significant attributes that underlie the various pools of assets and demonstrate the strong predictive power of the model through continual back-testing. Institutions applying a probability-of-default method for the first time will need to assess the reliability and accessibility of historical data sets that may be used to build the cumulative default probabilities and loss given default. The institution will first need to assess a standard definition of default and paths to default that might occur within a product line. Various industry sources of data can be used to assess probabilities of default over various economic cycles to supplement the institution s own experience. The performance of commercial mortgage-backed securities and RMBS, reflecting defaults, prepayment activity, and severity assumptions, for example, can be obtained from various ratings agencies and servicer reports. However, an institution using industry data must demonstrate comparability among the portfolios being measured. Whether default probabilities are driven by risk rating, past-due status, consumer credit scores, loan-to-value ratio, or something else, before the model is implemented it will need to be tested over a significant period of time to prove its predictive power. Regression Analysis Regression analysis can be a strong statistical tool to quantify or assess the predictive power of a particular set of assumptions. In particular, this type of analysis can be useful for developing support for quantitative associations between macroeconomic factors and losses. For example, one could use regression analysis on economic data such as unemployment and bankruptcy rates to forecast loss rates on consumer loan products. Using collateral pricing curves, one might use regression analysis on actual lossseverity data to assess the predictive power of a particular assumption (such as the impact of changes in home price indexes to change in loss given default). Institutions must assess the confidence level or imprecision acceptable with the use of statistical models. They should understand and assess imprecision in the models relative to the materiality impact of the allowance calculation and continually calibrate the models for actual performance. Given the specialized skills needed to interpret and test the results driven by statistical analyses, institutions might need to purchase additional quantitative tools or acquire new talent to implement these more complex methodologies. Conclusion There are several methods available to financial institutions to comply with the CECL model. While the final standard is not yet issued and the effective date has yet to be set, it s not too early for financial institutions to think about the methodologies available and how their existing allowance methodologies would convert to lifetime expected credit losses under the CECL model. Financial institutions will certainly need time to develop their sources of data, whether internal or external, and to subject their planned approach to adequate testing so that it will be robust enough to use well into the future and the FASB will take that into account when determining the effective date. 14

FASB s CECL Model: Navigating the Changes 15

Contact Information Chad Kellar is with Crowe Horwath LLP in the Indianapolis office. He can be reached at 317.208.2431 or chad.kellar@crowehorwath.com. Matthew Schell is a partner with Crowe in the Washington, D.C., office. He can be reached at 202.779.9930 or matthew.schell@crowehorwath.com. Published in December 2014. Crowe Horwath LLP is an independent member of Crowe Horwath International, a Swiss verein. Each member firm of Crowe Horwath International is a separate and independent legal entity. Crowe Horwath LLP and its affiliates are not responsible or liable for any acts or omissions of Crowe Horwath International or any other member of Crowe Horwath International and specifically disclaim any and all responsibility or liability for acts or omissions of Crowe Horwath International or any other Crowe Horwath International member. Accountancy services in Kansas and North Carolina are rendered by Crowe Chizek LLP, which is not a member of Crowe Horwath International. This material is for informational purposes only and should not be construed as financial or legal advice. Please seek guidance specific to your organization from qualified advisers in your jurisdiction. 2014 Crowe Horwath LLP FIA15904