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experience clarity //

CPAs & ADVISORS

CURRENT EXPECTED CREDIT LOSS (CECL) MODEL PROPOSAL – WHAT DOES IT ALL MEAN?

Debbie Scanlon, CPAPartnerdscanlon@bkd.com

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FINANCIAL INSTRUMENTS PROJECT – CREDIT IMPAIRMENT MODEL

WHERE WE HAVE BEENFinancial Crisis Advisory Group (FCAG)• Formed in 2008 by FASB & IASB

Recommendation• Explore alternative to “incurred loss model”• Reduce complexity by having a single model• Use more forward-looking information

Response• Proposals that result in more timely recognition of credit losses• FASB model—recognize all (lifetime) expected credit losses• IASB model—recognize some (12 months) expected credit losses until

significant deterioration threshold is met, then recognize lifetime expected credit losses

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WHERE WE HAVE BEEN

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Provision % of Net Charge Offs

< $500M

$500M - $1B

$1B-$5B

$5B - $10B

>$10B

Includes U.S. Banks & Thrifts

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WHERE WE HAVE BEEN

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ALLL to Total Loans

<$500M

$500M - $1B

$1B - $5B

>$5B

Includes U.S. Banks only

WHERE WE ARE TODAY

Probable incurred loss model2 primary components• General reserve• Specific reserve

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WHERE WE ARE TODAY

General reserve• ASC 450-10 (FAS No. 5)• Starting point

Historical losses over some period• Qualitative factors

Adjust historical losses to reflect the current portfolio• Internal factors, i.e., changes in underwriting• External factors, i.e., changes in economy• Check for directional consistency

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WHERE WE ARE TODAY

Specific reserve• ASC 310-10 (FAS No. 114)• Identify impaired loans• Specifically evaluate impaired loans for reserves

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WHERE WE ARE GOING

History• IASB’s 2009 ED

Expected (life of loan) cash flow modelRecognize impairment over time (as interest income is recognized)Conceptual appeal (to some) of reflecting the economics of lendingMajor concerns with operational issues

• FASB’s 2010 EDExpected (life of loan) cash flow modelAssume existing conditions remain the sameInterest income recognized by multiplying effective rate times net carrying amount of asset

• Boards redeliberate together

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WHERE WE ARE GOING

History (continued)• Jan 2011 “joint supplemental document (SD)”

Removes the concept of “probable”Introduces good book/bad book conceptsBoards continue to redeliberate based on comments about SDBoth boards develop 3-bucket approachFASB conducts outreach on model being developedJuly 2012 FASB tells IASB it has significant concerns about operability of 3-bucket model based on significant feedback from U.S. constituents (preparers, auditors & users)• Constituents question understandability, operability, auditability & workabilityFASB develops Current Expected Credit Loss (CECL) modelIASB continues to develop 3-bucket model

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WHERE WE ARE GOING

Feedback on the models (prior to December 2012)• Strong support for IASB model from IASB constituents

Although user feedback is subject to debate• Strong (3 - 1 margin) user support for FASB proposal• Preparers generally do not support recognition of full lifetime losses on day 1

Concern with projecting losses beyond a reasonably foreseeable time periodConcern that CECL does not reflect economics of lending

• Strong support for PCI model

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CURRENT PROPOSALDECEMBER 2012

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OPERATION OF CURRENT PROPOSAL

Scope• Covers loans, debt securities, trade receivables, reinsurance receivables, lease

receivables & loan commitments that are not classified at FV-NIAt each reporting date, recognize an allowance for expected credit losseson financial assets, i.e., loans, securities, derivatives, etc.• Expected credit losses are a current estimate of all contractual cash flows not

expected to be collectedPractical expedient – Meet both of the following; may elect not to recognize expected credit losses for financial assets measured at fair value with changes through OCI:• Fair value is greater than amortized cost (unrealized gain)• Expected credit losses are insignificant

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ESTIMATION OF EXPECTED CREDIT LOSSES – CURRENT PROPOSAL

Time Value of Money• Explicit or implicit• Discounted cash flow is an example of explicit—forecasts future cash flows (or

cash shortfalls) & discounts those amounts back to present value using the effective interest rate

• Developing loss statistics on the basis of the ratio of amortized cost written off due to credit loss to total amortized cost basis of the asset is an example of implicit―computed loss sta s c would then be applied to amor zed cost balance as of the reporting date

• As a practical expedient for collateral-dependent financial assets, may use method that compares amortized cost with fair value of collateral

Must continue to estimate costs to sell

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ESTIMATION OF EXPECTED CREDIT LOSSES – CURRENT PROPOSAL

Multiple Possible Outcomes• Requires that estimate of expected credit losses reflect both

Possibility credit loss resultsPossibility no credit loss results

• In making these estimates, a variety of credit loss scenarios are not required to be probability-weighted when a range of at least two outcomes is implicit in the method. Example methods where this requirement is implicit:

Loss-rate methodRoll-rate methodProbability-of-default methodProvision matrix method using loss factors

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ESTIMATION OF EXPECTED CREDIT LOSSES – CURRENT PROPOSAL

Loan Commitments• Required to recognize all expected credit losses for only those commitments

not measured at fair value with changes through net income• Estimate credit losses over full contractual period during which the entity is

exposed via legal obligation to extend credit, unless unconditionally cancellable by the issuer

• For the period of exposure, must consider:Likelihood funding will occurEstimate of expected losses on commitment expected to be funded

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EXAMPLES

EXAMPLE 1 – LOSS-RATE APPROACH

Entity A is a national bank that provides 5-year amortizing commercial mortgage loansThe entity estimates expected credit losses for pools of similar asset types by:• Segregating into credit risk ratings• Applying a current estimated loss-rate specific to each credit risk rating to the

amortized cost basis of the assets in that rating categoryEntity A develops historical loss rates on the basis of its historical loss data for 5-year commercial mortgage loans• Form static pools by grouping borrowers by risk rating at beginning of year• Follow each pool from that point forward through the life of assets within the pool• For each pool, a historical loss rate applicable to the risk rating is determined

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EXAMPLE 1 – LOSS-RATE APPROACH (CONTINUED)

To develop its current expected loss rate, Entity A updates historical data (computed on the previous slide) to reflect:• Changes in current conditions• Reasonable & supportable forecasts that differ from historical experience

Entity A has now developed current expected loss rates by risk rating, based on its historical loss rates, adjusted for current conditions & reasonable & supportable forecasts about the futureFor this example, let’s assume they have computed the following:• 0.5% for loans with a “Pass Category 2” risk rating• 3.0% for loans with a “Pass Category 4” risk rating• 8.0% for loans with a “Special Mention” risk rating

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ENTITY A – EXPECTED CREDIT LOSS ESTIMATE

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Pass Category 2 Pass Category 4 Special Mention

Expected loss rates 0.50% 3.00% 8.00% 1.59% *Ending balance 27,500$ 10,000$ 2,500$ 40,000 Expected credit loss estimate 138$ 300$ 200$ 638$

* 1.59% weighted-average loss rate is calculated as total expected credit loss estimatedivided by ending balance

December 31, 20X1($ in 000s)

Risk Rating Category

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DAY 2 ACCOUNTING – LOSS-RATE METHOD

Assume the following quarter Entity A expects the loss rates used on previous slide will be the same for this quarter-end, because conditions remain consistent with the economic conditions expected at March 31, 20X2

Also, assume various activity has occurred, such as some credits have deteriorated, some have been paid down, etc.

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ENTITY A – DAY 2 – EXPECTED CREDIT LOSS CALCULATION

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Pass Category 2 Pass Category 4 Special Mention

Expected loss rates 0.50% 3.00% 8.00% 1.58% *

Beginning balance 27,500$ 10,000$ 2,500$ 40,000$ New originations 2,300 - - 2,300 Paydowns on O/S loans (1,510) (560) (130) (2,200) Loans charged off - - (9) (9) Credit migration (320) 115 205 - Ending balance 27,970$ 9,555$ 2,566$ 40,091$ Expected credit loss estimate 140$ 287$ 205$ 632

* 1.58% weighted-average loss rate is calculated as total expected credit loss estimatedivided by ending balance

March 31, 20X2($ in 000s)

Risk Rating Category

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ENTITY A – ADJUSTMENT TO ALLOWANCE FOR MARCH 31, 20X2

Before the adjustment, Entity A would have an allowance for expected credit losses balance of $629,000 (that is, $638,000 allowance as of December 31, 20X1, minus the $9,000 of charge offs during the quarter)As a result, the entity would record an additional provision of $3,000 for the quarter ended March 31, 20X2, increasing the ALLL to $632,000Although Entity A’s estimate of expected credit losses has increased from previous quarter, the estimate is largely consistent with the previous quarter• Extent of credit-quality deterioration experienced during the quarter consistent

with entity’s expectations• Decrease in credit risk in the portfolio resulting from paydowns offset by

increases in credit risk on new loans

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EXAMPLE 2 – PROBABILITY-OF-DEFAULT (POD) METHOD

Another acceptable method of estimating the loss rates – The product of POD statistic & loss-given default statisticUnder this method• The POD statistic would reflect likelihood of default occurring over remaining

life of the asset, which gives rise to a shortfall in collection of contractual cash flows

The POD statistic might be derived from:• Entity’s own historical loss experience• Externally available data, such as a rating agency transition matrix, which uses

the data over full contractual term of financial assets to capture cumulative default experience

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EXAMPLE 2 – PROBABILITY-OF-DEFAULT (POD) METHOD

The POD statistic would then be updated to reflect current conditions & reasonable & supportable forecasts about the futureNext, the loss-given default statistic would reflect the severity of credit loss if borrower defaultsThe loss-given default statistic could be based on studies performed on historical loss experience or based on externally available data

WHAT?

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EXAMPLE 3 – BASE COMPONENT & CREDIT RISK ADJUSTMENTThe base statistical estimate of credit loss may reflect historical average of credit losses that would be expected for financial assets with similar risk characteristicsThe base statistical estimate alone will not be adequate because it does not consider current & forecasted conditionsThus, credit risk adjustment is necessary to adjust the base statistical estimate so the current expected credit loss estimate reflects current conditions & forecastsThe credit risk adjustment would be estimated using macro-level factors such as• Management’s evaluation of current point in the economic cycle• Evaluation of borrower behavior & collateral values• Recent trends in economic conditions

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By-vintage basis

Collective estimation method & an individual asset estimation method

Provision matrix

MANY OTHER ACCEPTABLE METHODS IN THE PROPOSAL

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PURCHASED CREDIT IMPAIRED FINANCIAL ASSETS

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PURCHASED CREDIT IMPAIRED FINANCIAL ASSETS

Discount embedded in the purchase price that is attributable to expected credit losses should not be recognized as interest income

Allowance for expected credit losses shall be recognized at acquisition date as an estimate of all contractual cash flows not expected to be collected

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OPERATIONAL CONSIDERATIONS

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WHAT WILL YOU HAVE TO CONSIDER UPON IMPLEMENTATION?

Calculations of historical losses must still be tracked & measured – Must decide how far back is appropriate for purposes of forecastingCurrent requirements for documentation of qualitative factors must stay in place (and likely expanded)Once an approach is selected, must determine what “systems” will or can be usedForecasts will require detailed documentation & computational support that can be updated regularlyMonitoring processes over loans will need to be revised to allow that process to gather more data to assist in forecastingEducation of board, senior management & various other lending personnel

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WHAT DOES ALL THIS MEAN?

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Preparer concerns with FASB’s model• Believe it will result in understatement of net asset value at amortized cost on

“Day 1” by recognizing expected credit losses that are already reflected in purchase price of transaction price

• Fails to “match” timing of recognition of credit loss expense & interest income• Impact on regulatory capital• Lack of historical information about “life of loan” losses• Many believe they cannot forecast beyond foreseeable future (although FASB

has indicated most preparers they had test the model agreed that past, current & reasonable & supportable forecasts should be used to develop the loss estimate)

• Few securities will be eligible for practical expedient for FV-OCI• Why continue with TDR guidance under a life of loan model?

WHERE WE ARE GOING

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Day 1 EOP 1 EOP 2 EOP 3 EOP 4 EOP 5

Current US GAAP (as applicable)CECL (as proposed)3-Bucket (based on draft)

Initial

ActualRevised

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UPDATE ON FASB PROGRESS

Currently in process of redeliberating significant issues raised through feedback received on the December 2012 proposalTentative decisions reached as of March 12, 2014:• Board will continue to refine the CECL model• Proposed update will be clarified for the following:

Reversion to historical average loss experience for future periods beyond reasonable & supportable forecastsConsider all contractual cash flows over life of related financial assetsConsider expected prepayments but not extensions/renewals/modificationsEstimate of expected credit loss should always reflect risk of loss, even when that risk is remoteIn addition to using a discounted cash flow model, an entity would be allowed to use loss-rate, probability-of-default or provision matrices using loss factors methodsImplementation guidance for adjustments to historical loss experience

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UPDATE ON FASB PROGRESS (CONTINUED)

• For purchased credit impaired loans, would be required to allocate to each individual asset the noncredit-related discount or premium resulting from acquiring a pool of assets

• Clarification of cost basis adjustment for TDRs to require an increase in cost basis of restructured asset through a corresponding increase in allowance for expected credit losses in certain TDRs

• No guidance at this time will be provided on when an entity ceases to accrue interest income

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Tentative decisions reached as of March 12, 2014 (cont’d):

FASB NEXT STEPS

Continued redeliberations

Looks like IASB is going their own way

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LINKS TO BKD THOUGHTWARE™ ON CECL

http://www.bkd.com/articles/2013/white-paper-the-new-fasb-credit-impairment-model.htm

http://www.bkd.com/articles/2014/update-on-fasbs-financial-instruments-projects.htm

http://www.bkd.com/articles/2013/fasb-credit-impairment-model-additional-resources-released.htm

http://www.bkd.com/docs/pdf/Feedback-on-FASB-Credit-Impairment.pdf

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THANK YOU

FOR MORE INFORMATION // For a complete list of our offices & subsidiaries, visit bkd.com or contact:

Debbie Scanlon, CPA // Partnerdscanlon@bkd.com // 713.499.4610

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