Pub. 5 2016 Issue 1

The CommunityBanker 10 F E A T U R E It’s Broken s you might imagine, much attention has been given lately to the Financial Accounting Standards Board (FASB) Current Expected Credit Loss (CECL) Model and rightfully so. It will certainly have a significant impact on the largest and smallest of banks in the system. However, as I listened to a recent public meeting with various stakeholders ranging from the FASB to the various regulatory bodies to lobbyists and then ultimately to the banks being impacted, I thought to myself this is a meeting that is too late and yet too early. One takeaway many had from the February 4 th meeting was that the incurred loss model is certainly broken and it certainly needs to be fixed. It does not take one long to reach this conclusion if you sampled ten bank’s incurred loss models today. In fact, nearly 60 – 85 % of ALLL models today are primarily made up of qualitative factors as their loss history ranges generally between 10 – 30 basis points. While most banks are utilizing the eight qualita- tive factors recommended in the interagency statement, many banks continue to have an increased amount of unallocated reserves. A recipe for disaster exists as it relates to directional consistency in the components of the ALLL if banks do not employ more complex methodologies to increase the quantita- tive component such as loss emergence period (LEP) – thus the inherent flaw in the incurred loss model. Let’s Fix It Since I started my career more than 10 years ago, there have been a couple of themes that surround the current ALLL model I have picked up on while talking to bankers: • Our current model does not allow us to support high- er reserves, and if we do provide for higher reserves, they are very difficult to substantiate • We need a standard that allows us to reserve in good times for when times are bad and vice versa The proposed CECL Standard will likely be released during the second quarter of 2016. Could this Standard be the solution to these concerns? Perhaps. The proposed Standard certainly introduces more complexities; however, it also establishes new concepts such as life of loan, reasonable and supportable forecasts and reversions to the mean as well as how these concepts might impact loss analyses over a more extended period of time. As we prepare for the final standard release, I believe there are three key elements we can use to sharpen the saw and build a roadmap. 1. Know your Data: A detailed plan around gathering, storing and analyzing historical data will benefit you significantly as you prepare for CECL. The following are a couple of examples: a. Net Charge-Off history for loss modeling: Under- standing the various components of your losses, such as the probability of default (PD) and loss given default (LGD) related to your portfolio cohorts can provide you with benefits in other areas of your bank such as loan pricing. Given the unique nature of many community bank portfolios, having this level of granularity will not only allow you to more accurately project losses, but will also give you the tools to more effectively price loans. A If It’s Broken, Let’s Fix It By William (Bill) J. Bossong, CPA, CBA