How CECL Can Improve Your Bottom Line

Bankers and other financial professionals tend to approach the new CECL (current expected credit losses) accounting standard with an enthusiasm typically reserved for toothaches and telemarketer calls, and may well be skeptical of the potential of CECL to bolster their institutions’ bottom lines.

The opportunities for better business outcomes, however, are real — though they may be obscured by the scope of the CECL transition. Admittedly, adopting CECL over the next two years will be complex and burdensome because financial institutions must:

• Develop a CECL implementation plan.
• Assess the availability and quality of data they need to estimate anticipated losses.
• Reassess loan pools.
• Choose estimation methodologies that accommodate their lending products and portfolios.
• Consider changes to financial and managerial reporting requirements.
• Limit their financial, operational and regulatory exposure.

The 2017 MST financial institution survey which surveyed banks and credit unions across the United States found that the vast majority expected greater complexity and higher costs with CECL.

Percentage of MST survey respondents who expect CECL to:

Increase complexity of compliance                                           84.7%

Increase demand on internal resources, including staff         83.7%

Increase cost of compliance                                                      68.4%

Change the types of loans we make                                            9.2%

Have substantial negative impact on profitability                       6.2%

Reduce our loan losses                                                                 4.1%

The lending outlook shifts dramatically under CECL

Seeing the opportunities in CECL starts with shifting your mindset on lending. At the MST 2017 National ALLL Conference, allowance-accounting expert and MST Advisor Dorsey Baskin shared a biblical analogy to explain the required shift in perspective: 

With CECL, “all loans are born in sin,” Baskin said in a seminar at the MST conference. “Comparatively, today’s loans ‘fall from grace’ as their risk ratings sink into impaired territory.” 

The new presumption under CECL will be that all loans have the potential to fail. This puts the onus on financial institutions to create what can be sophisticated models pulling a mix of internal portfolio data and external economic data to attempt well-thought-out predictions about the lives of their loans. 

“We no longer assume loans are good until they become impaired, that a lender expects to collect all the cash flows at the time a loan is made until something happens to impair it,” Baskin said. “That notion underlying GAAP for decades is going away, and it can be hard to get your head around that when implementing CECL.” 

ABA sees opportunities under CECL

In June 2016, the American Bankers Association issued a commentary titled “CECL: An Opportunity for Banks?” arguing that despite all the challenges of converting to CECL accounting, banks’ financial positions could well improve thanks to the new standard: 

“Long-term profit and loss are, for all practical purposes, determined at origination,” the ABA commentary observed. “Bank earnings no longer will necessarily be affected by the economic cycle, but by management’s forecast of the cycle.” 

“Bank earnings no longer have to be guessed when they occur, but will be recorded when management forecasts them to be — at origination.” This all means that banks will theoretically have more control over capital and that CECL potentially will allow bankers to minimize earnings volatility. 

“If minimizing volatility can increase the effective deployment of capital, then CECL could help bank profitability.” 

Furthermore, ABA argues, the rich data used to create CECL models also will allow financial institutions to price their products more accurately, again creating an opportunity to bolster profitability by creating products that better suit the needs of borrowers and lenders alike.  

More advantages of CECL

Other potential advantages of CECL could include, but are not limited to: 

• Parallel modeling: Building CECL models now allows institutions to compare the results of different data methodologies to find opportunities to improve their business. “Right now, I am running migration and PD/LGD models,” said Kristen Deitrick, Financial Accountant at Washington Trust in a recent MST article. “I can look at how the allowance calculations differ and how they react with different variables. This helps the CFO to inform the board and manage the capital of the bank for better decision making.” (Related: “CECL: What is the impact to executive compensation?”)
• Takeover potential: As the ABA noted in their June 2016 commentary, institutions that have developed thorough, sophisticated CECL models could be better prepared to ride out future volatility. That could make institutions attractive acquisition targets.

At the MST National ALLL Conference, Vince Milano, CPA and quality control director at Postlethwaite & Netterville concurred, “I think there’s a lot to be learned from these methodologies, from really analyzing your portfolio in depth and looking at past experience and combining all that with forward-looking information. This might make you more attractive if you’ve implemented this properly. It can give an acquirer a really good view of your portfolio.”

• A single point of truth: Building a robust data model that everybody in the institution can see and learn from can be a considerable boon. From the board room to conference calls with investors, everybody is seeing the same data and the same conclusions. The data models can become, in effect, an easy-to-access form of financial infrastructure.

The time to begin preparing for CECL is now.  Although there are some who remain idle, maintaining a false sense of security when considering we’re still at least a couple years out from CECL’s mandatory adoption dates, most recognize the fact that this conversion to the new standard will take time, and that the sooner you can get started the better.  Moreover, waiting to begin the process puts you at the mercy of supply and demand, should you need external expertise.  

The silver lining to the CECL transition pains is the fact that CECL is giving financial institutions an opportunity to build rich data models that can help them better understand their marketplace, loan portfolio and risk, and thus impact the bottom line. CECL is certain to give everybody a workout for the next two years, but savvy institutions have a chance to emerge stronger from the experience.