Your bank or credit union could be facing an increase in overhead costs due to a standards change, and that cost increase will probably get passed on to you. The Financial Accounting Standards Board (FASB) introduced a new standard known as current expected credit loss (CECL) that affects any financial institution or firm registered with the Securities and Exchange Commission. These institutions have until the fiscal year that starts Dec. 15, 2019, to adopt the new standard.
What Is CECL?
Essentially, CECL assesses loan risk in a different way than before. It reviews loans that share similar risk characteristics on a collective basis. For financial institutions, that means they’ll have to develop new forecasts through their certified public accountant.
CECL also affects how institutions manage credit. Current expected credit loss models two things for a financial institution: the contractual cash flows the financial institution doesn’t anticipate collecting from a financial asset and its commitment to extend credit.
Are you wondering how the current expected credit loss model could affect your business finances? The CECL standard:
- Applies to every financial instrument measured at amortized cost
- Removes the concepts of incurred and probable threshold
- Requires a reasonable, supportable forecast for the life of the instrument reserve
- Uses a risk-weighted model, presenting an actual model of potential loss risk
- Uses time value of money based on a discounted cash-flow model
CECL requires that its risk model uses the effective interest rate as the discount rate. Also, the probability of default looks at different assets to determine which category things fall in.
Loan and Lease Losses
CECL also changes how portfolios represent Loan and Lease Losses (ALLL). Lenders must post a reserve from the beginning of the loan against the lifetime expected credit loss. Previously, lenders could reserve for losses on an incurred basis. This change impacts many areas. Loan pricing, the amount of capital that’s allocated to a portfolio lending strategy, the financial institution’s products offered to consumers, and the institution’s net income are all impacted. That’s because the new ALLL applies to pre-tax operating income. All these changes add up to increased compliance costs.
How to Mitigate CECL Impacts
Your business finances could be impacted by these changes. While lenders can partially mitigate the required reserve against the lifetime expected credit loss using mortgage insurance, that does not reduce all costs down to their current level. CECL also does not allow the use of other forms of credit enhancement since they can be independently excised from a loan. That means using pooled insurance. Credit default swaps and other freestanding contracts are out.
Financial institutions are not the only businesses affected directly by CECL. Non-financial services businesses that hold financial assets must also use its standards. CECL also applies to trade and lease receivables and other financial instruments. It also updates the impairment guidance for available-for-sale securities.
The implementation of CECL at the end of 2019 will bring a number of changes. Preparing for the required changes will make the adjustment easier. Start now to be ready for the changes needed by the fiscal year beginning Dec. 15, 2019.
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