Banks are not yet prepared for pending new requirements on how to reflect potential loan losses in financial statements and don’t even agree on the significance of the change associated with the new rules, according to a recent survey by RapidRatings and Compliance Week.
In a poll of representatives at more than 100 financial institutions of varying sizes, only 23 percent said they had a plan in place for how to comply with a requirement from the Financial Accounting Standards Board directing them by 2020 to use a more forward-looking approach to project current expected credit losses (CECL) resulting from their loan portfolios. Another 28 percent said they did not have the data and model ready to comply with the standard, and 32 percent said they weren’t sure.
Despite expert predictions that new methods of reserving for loan losses would represent a seismic shift in bank accounting processes, banks of all sizes have divergent views on the significance of the new rules. Only 40 percent of respondents said they expect substantial changes to their policies, processes, or technology systems as a result of the new standard, while 60 percent said they expect changes to be minimal. Only 33 percent said they’d begun planning.
James H. Gellert, CEO at RapidRatings, says he finds the results perplexing. “This is being described by some as the most significant accounting change in the history of banking,” he says. “Even discounting that statement somewhat, how can it be that 60 percent of people think it’s no big deal?”
Both U.S. and international banks are required to alter their method for reflecting loan losses because of changes in both U.S. and international accounting rules brought on by the financial crisis of a decade ago. FASB and the International Accounting Standards Board heard the outcry that financial institutions did not adequately inform investors of trouble expected with debt instruments because existing rules prohibit them from recognizing expected losses until losses actually occur or are imminent.
Under new rules for GAAP, U.S. banks are required beginning in 2019 to book allowances for loan losses using a “current expected credit loss” model. That means banks are required to use some projection and estimation to determine what their losses might be and reflect those in financial statements. New requirements under International Financial Reporting Standards also require a more forward-looking approach, although the model is different from that adopted for GAAP.
“The data show more banks are under-prepared or yet to be prepared. That suggests the second half of 2017 and 2018 are going to be extremely busy for them.”
James H. Gellert, CEO, RapidRatings
In FASB’s principles-based standard, the board left financial institutions great latitude to determine exactly how to calculate the expected loss number that they will report. That has produced some angst at financial institutions over how to develop a model that will pass muster with auditors and regulators.
With only one-fourth of poll respondents indicating they’ve worked out a method, there’s still plenty of work to be done to identify a plan, said Gellert. “The data show more banks are under-prepared or yet to be prepared,” he said. “That suggests the second half of 2017 and 2018 are going to be extremely busy for them.”
The RapidRatings/Compliance Week poll shows plenty of diversity in how banks are approaching the modeling question, with 29 percent indicating they will lean most heavily on historical loss data to develop their methodology for estimating losses in their commercial and industrial loan portfolios. Another 21 percent said they will develop a migration analysis, and the largest share at 36 percent said they were using some other method not specified in the survey.
Gellert was surprised to see so few banks planning to calculate their expected loss by factoring the probability of default with the share of assets that might be lost if a given borrower defaults. Across all respondents, only 14 percent indicated this will be their method of choice, and most of those were smaller banks rather than larger banks. “That’s an interesting response,” he said. “I would have expected many more, especially among the larger banks, to need or want that data.”
Compliance Week and RapidRatings asked respondents to a CECL poll to answer: Do you have in place the data and the model inventory needed to prepare for CECL?
When asked what they expect to be the biggest obstacle to achieving implementation of the new CECL approach, banks landed all over the map. Nearly half said it would be a combination of reasons including managing an overwhelming amount of data; answering questions from auditors, regulators, and investors; needing additional talent or personnel; dealing with outdated technology; or planning capital. In terms of standalone responses, data management was the most-often identified chief challenge. “It’s important for people to realize there will be a tremendous amount of data for people to collect and manage,” Gellert says.
Additional key findings from the survey include:
32 percent of banks said the current team will be trained to address CECL as an added duty or responsibility, while only 6 percent plan to have a dedicated CECL team separate from the accounting close staff;
28 percent of banks said they have the data they will need to comply with CECL, while the remainder do not or do not know;
31 percent said they will use an in-house tool to identify and calculate assets at risk of loss due to a given borrower’s default, while 35 percent will use a third-party tool; 60 percent said they believe their current tools are adequate to meet their needs; and 72 percent plan to use a combination of quantitative and qualitative information to calculate probabilities of default.
Gellert also was surprised to see survey respondents indicate they have more public companies than private companies as obligors in their commercial and industrial loan portfolios. About 40 percent indicate they will use similar or the same modeling to determine their probabilities of default for such companies, while the rest are split on how they will differentiate between public and private entities.
“Across the industries of our clients, which include banking, companies underestimate the percentage of private companies with which they do business,” says Gellert. That could have an effect on the type of data banks will need to arrive at their expected losses under CECL. “A lot of firms that deal with private companies don’t always have the information they need to properly analyze them, but they need to have processes and procedures to assess private companies. That is maybe going to be a bigger burden than they expected.”
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