“Wise men say, and not without reason, that whoever wished to foresee the future might consult the past” -Machiavelli
Well, that pretty much sums the stance taken by the Financial and Accounting Standards Board (FASB) on the much awaited (read controversial) regulatory guidelines for calculating credit loss allowance by financial institutions. As per the latest mandate, FIs need to take into consideration historical data, present condition, and future economic scenario to arrive at ALLL (Allowance for Loan and Lease Losses). The rider on the CECL Compliance mandate – banks need to maintain reserves for all loan types, impaired or not.
Phew!
That’s a massive amount of data to be collected and to add to it, the provision for ALLL needs to be made at the very outset a loan is booked! As debated and highlighted by numerous groups and forums, the CECL Compliance mandate has the potential to make a significant dent in the earnings of FIs, shoot up the interest rate, and worsen the situation in case of an economic downturn. The next step? A much-needed huddle of chief credit officers, chief financial officers, chief risk officers, chief information officers, compliance officers, and business intelligence officers to prepare for the future.
Carrot or stick?
The FASB is on a risk aversion mode given the financial crises of 2008 when lack of sufficient loan reserves spiraled the situation out of control. It is true that bankers need to cushion themselves, however, it should not be done at the cost of good business! As per Thomas J. Curry, Comptroller of the Office of the Comptroller of the Currency (OCC), the ALLL can shoot up to as much as 30%-50%! And that’s what is causing all the brouhaha. ALLL estimation is what is driving the banking industry into a frenzy. At present almost all is conjecture. Until and unless FASB comes up with the final plan, and unless there is implementation, it is slightly difficult to guess whether the banking sector is being dealt out carrot or sticks.
CECL Compliance: Getting down to the nuts and bolts
Implementation of CECL Compliance for public banks is expected by 2018 and for private banks by 2020. The interim period is crucial for belling the new standard for calculating ALLL. If we go granular to the requirements, it is not that indecipherable.
Challenge 1: Documentation needs for CECL compliance
The primary issue with CECL framework is the re-juggling of data collection and data maintenance by FIs. With the revised ALLL estimation requirement, the number of data points that banks need to collect has more than doubled. In addition to maintaining the usual charge-offs, recoveries, beginning and ending balance pools, banks also need to add data fields like loan duration, individual loan balance, and risk ratings to come to a reasonable estimate. Collecting data is one part, the other part is to maintain the added data for audit requirements. Collecting necessary information is the primary step that banks need to do right to transition to the CECL model. It is central to the estimation of life of loan losses. More the data points, the better off you will be in the game of averages.
Solution: Document Management System
While large banks might already be maintaining their data in their core systems, the mid-sized and small banks need to up their ante. Data availability and accessibility are the keys here. Banks need to address the issue of efficiently pulling out the added information needs from existing loan documents and also ensure a cost-efficient process for the same? In the incurred loss model, it was sufficient to have aggregate pool level information, however, now banks require loan level losses to build historical loss rate. Banks might think their core systems store historical information, but in reality, they store an average of 13 months of data, which is clearly insufficient for banks to bank on. Document Management Systems are adept at collecting data from across touch points and maintaining them at a central repository that can be accessed anytime and adheres to regulatory mandates for data preservation.
Challenge 2: Calculation complexity
Manual spreadsheets are no help given the extensive calculations (both qualitative and quantitative) that banks are expected to maintain henceforth. Therefore, banks need to move away from manual processes to a more streamlined and automated system that puts in place workflow and documentation needs and allows banks to develop and run test models (like the vintage model that takes into account the loss calculation over loan life) to tackle calculation complexity.
Solution: Workflow Automation and Business Rules Management System
Majority of big banks might already have rules system in place but if its hardcoded, it’s not of much help. The old model is based on incurred losses during a given 12-month period, while the new model requires banks to account for all expected losses over the life of each loan. The American Bankers Association calls this life of loan concept “the biggest challenge of CECL (since) credit losses expected over the life of the loan are effectively recorded upon origination.”
With the CECL framework becoming effective in a few years time, banks need to figure out which estimation suits their need. A hard-coded rule set will make a bank lose out on the much-needed flexibility and agility. Business Rules Management Systems are software applications that work in tandem with a core system or a BPM. The USP of a BRMS is that it allows rules to be externalized from the core system, and therefore, can be changed without depending on vendors or coders to update/modify rules as necessary.
Challenge 3: Deciphering Trends
Forecasting expected Loss is one of the major pain points for banks. Manual processes cannot be expected to model and calculate the life of loan losses. Discounted cash flow methods and vintage models are some of the loss rate methods defined by FASB, and banks need a system in place for execution and maximum utilization of these methods. Banks also need to know how loans are migrating with time to different risk categories and if the ALLL estimation model is in tandem with the bank’s loan portfolio.
Solution: Analytics and Reporting tool
An analytics-based forecasting system can provide end-to-end analytical support to banks for forecasting loss rates. Such systems ingest data from multiple sources, analyze data in its core framework, which has Topology Manager, Core Analytics, Business Analytics, and Model Generation modules, and feed processed data to other applications. A reporting system utilizes the information analyzed by the core analytics engine to generate reports on the basis of which banks can decide if their loan portfolio needs to be overhauled, if certain loan types are to be avoided that are producing a skew in the ALLL estimate and such decisions can significantly impact a bank’s capital planning needs.
That’s ALL there is in the game!
Not everything is as bleak as it seems. Although the initial phase seems to be a tough nut to crack, there is a silver lining to CECL too! Assuming that you start analyzing and preparing for CECL today, and your ALLL is as close to the actual risk of your portfolio, it will be the game clincher for your bank! You can make the maximum utilization of your capital when your ALLL is low, as well as get more than sufficient cover during downtime. Sounds like a twofer? You bet!
