Specialty lenders need to start preparing for CECL now
The modeling, data and other decisions you need to make today
INSIGHT ARTICLE |
Historically, specialty lenders do not recognize loan losses until they are incurred. Since the financial crisis, however, certain stakeholders have asserted that this practice delayed recognition of loan losses. As a result, the Financial Accounting Standards Board (FASB) recently issued a new accounting standard that will apply to specialty lenders and require a current expected credit loss (CECL) model, which means that lenders will have to recognize an allowance for those loan losses that are expected to occur throughout the life of the loan on the day the loan is originated.
CECL will require that lenders book an estimate of all expected loan losses based on the contractual life of the loan, taking prepayments into consideration, drawn from historical loss experience, current and forecasted economic and market conditions and a variety of other qualitative and quantitative factors.
Many specialty lenders do not have the tools or processes in place to prepare the forecasts CECL will require. Given that FASB’s final guidance on CECL was issued in June 2016, specialty lenders can begin to plan now for implementation.
To prepare for CECL, some actions specialty lenders should begin to take are:
- Evaluate your organization’s ability to project loan duration and life-of-loan loss rates
- Determine how to group loans with similar risk characteristics
- Determine new policies and procedures needed to comply with CECL
- Look at your systems to see if you are ready to capture, analyze and report the data CECL will require
- Review your forecasting capabilities in light of CECL and upgrade as necessary
- Consider the impact of the adoption of CECL on your debt agreement covenants
Specialty lenders will need to evaluate the various modeling options available to them based on factors such as the types of loans you make, how your market and loan portfolio are likely to react to various economic scenarios, and your unique data and reporting capabilities. Potential models include:
- Static pool or vintage analysis–tracking lifetime loan losses by origination pool
- Risk migration–using historical information on how categories of delinquency or other appropriate credit quality indicators ultimately migrate into loan losses
- Probability of default–a discounted cash flow methodology that generally evaluates the likelihood that loans will go into default and the estimated loss that would occur upon default considering collateral and other relevant factors
CECL will likely mean you will need to make changes to how you collect, analyze and report data. Following are five key data questions you’ll need to answer:
- What data will you need to start capturing and tracking to meet forecasting demands?
- How will you need to adapt your loan origination and administration practices and tools to meet these new data demands?
- Do you have sufficient historical loss data to estimate life of loan expected losses?
- Do you need to update data retention policies?
Data collection can be further complicated if the loan portfolio includes loans that have been acquired rather than originated, or if there has been a change in the loan system being used.
Additional information on CECL can be found in our white paper, Financial instruments: In-depth analysis of new standard on credit losses. The white paper provides a detailed look at the key components of Accounting Standards Update 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.