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Financial Institutions May Have a Lower Allowance for Loan Losses Under CECL — And That’s OK!

Unless you’ve been living under a rock the past six years, you know that effective January 1, 2023, all remaining calendar year-end companies (both public and private) must adopt ASC 326, Financial Instruments – Credit Losses.

Accounting Standards Update (ASU) 2016-13

The new accounting standard was issued in 2016 with Accounting Standards Update (ASU) 2016-13. ASU 2016-13 impacts any entities that carry financial assets at amortized cost basis. However, it was primarily issued to replace the previous “incurred loss” model for reporting credit losses that financial institutions utilized in determining their allowance for loan losses. Under the incurred loss model, recognition of credit losses was delayed until the loss was probable.

Unfortunately, the financial crisis of 2008/2009 exposed the inherent weaknesses in the incurred loss approach to recording credit losses. Many financial institutions were unable to report credit losses because they had not yet met the requirements (the probable threshold) from an accounting perspective. Simultaneously, most analysts at the time were using their own set of estimates and assessments based on forward-looking information to devalue these securities held by banks. This resulted in a disconnect between the requirements under generally accepted accounting principles (GAAP) and the market's expectations.

As a result, ASU 2016-13 was issued to provide financial statement users with more decision-useful information about expected credit losses on financial instruments and other commitments to extend credit. Under the standard, the incurred loss model was replaced with the current expected credit loss (CECL) model. Under CECL, earlier recognition of credit losses was required, and it removed the probable threshold. CECL considers future economic conditions and requires companies to record the lifetime expected credit losses on day one.

Given the new requirements under CECL, most observers ascertained that the allowance for loan losses would generally be higher under the new accounting standard. This is reasonable given that the allowance for loan losses today is essentially an annualized number, or one year’s worth of losses, and if you move from a year of losses to losses over the lifetime of a loan’s term, one will deduce that the allowance would increase.

Given the above, it came as a surprise to many financial institutions beginning to run their parallel CECL models in preparation of adopting the standard, to find that their allowance for loan loss reserve decreased instead. However, when taking a deeper look at the situation, it becomes more understandable how this may occur. Historically, when financial institutions determined their allowance for loan losses, it normally fell in the 1.00% – 1.50% range. If the calculation were completed and a bank found it was lower than 1.00%, many felt this was under reserved and would adjust qualitative factors to get back to the traditional range. Post-Great Recession, many regulators pushed for a higher allowance. Whether it was considered a guideline or a benchmark, most institutions increased reserves to meet it. This typically resulted in most financial institutions having an “unallocated” portion of the allowance reserve.

If you need further guidance or have any questions on this topic, we’re here to help. Please do not hesitate to reach out to our trusted experts to discuss your specific situation.

Use of qualitative factors is still required

Under CECL, the use of qualitative factors is still required, however they are now built into and captured under the quantitative models using reasonable and supportable forecasting data. Given that overall economic conditions have generally been positive, albeit the recent downturn, this may result in a financial institution having a lower than expected CECL reserve as compared to the more conservative modeling and qualitative measures of yesteryear. Additionally, under the new methodology, there should no longer be unallocated portions of the reserve if not fully supportable.

Depending on the composition of the loan portfolio of a financial institution, the measures used to estimate future expected credit losses may not result in significant reserves. Many of the institutions we have worked without throughout New York in the recent past have not experienced significant credit losses. However, even with these lower losses, many financial institutions have maintained allowances to reach the 1.00% – 1.50% expected range, with many even higher during the pandemic.

If your financial institution completes its CECL modeling and it results in a lower reserve, do not fret! Regulators have been stating there will be no targets or ranges for financial institutions when it comes to adequacy of allowances under CECL. In effect, there will be no pre-conceived benchmarks in place when examiners review after the adoption of CECL and going forward. The objectives are not to drive banks to maintain allowance levels approximating peer groups, but rather to maintain allowances appropriate for their own specific portfolios.

If your CECL modeling does result in a lower allowance than under the incurred loss model, regulators will request, and you should be prepared to deliver, documentation and support for why that is. It is expected examiners will challenge lower allowances under CECL if the inputs into the allowance estimate, including the historical loss information and management’s forecasts, assumptions and judgments do not appear reasonable and are not properly supported.

Specifically, the FDIC has indicated the CECL allowance should:

  • Have support and documentation
  • Allowances that are reasonable and supportable
  • Make sense for the institution, taking into consideration the institution’s risk appetite, underwriting standards, the quality of its loans and performance and other characteristics of its portfolio, and
  • Be based on an institution-specific analysis of the loans in its portfolio and the other assets and exposures within the scope of CECL.

In the end, if the financial institution can show the path of how it got from Point A to Point B and is able to support the decisions made, the regulators should accept of the ultimate result.

If you need further guidance or have any questions on this topic, we’re here to help. Please do not hesitate to reach out to our trusted experts to discuss your specific situation.