CECL: The Most Sweeping Change to Bank Accounting Ever
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In June 2016, the Financial Accounting Standards Board (FASB) issued a new accounting standard governing the way companies evaluate and account for impaired loans and securities. The new standard, ASU 2016-13, replaces the “incurred loss” impairment methodology with the Current Expected Credit Loss (CECL) model, marking a significant shift in the way credit losses on many financial assets – especially loans – are recorded.
While the new CECL standard is applicable to every organization required to issue financial statements in compliance with U.S. GAAP, financial institutions face the heaviest implementation burden. Not only does CECL impact internal accounting policies and procedures, it will also have a material impact on financial statements, and subsequently affect how companies manage their capital.
As a result, companies may encounter issues related to profitability, as profit and return measures are likely to be adversely impacted. Since most financial institutions incorporate some of these measures in their incentive pay programs, issues related to “pay-for-performance” are likely to arise.
In addition, it is likely that the implementation of CECL will bring with it additional scrutiny from shareholders, and proxy advisory firms, as the levels of disclosure will substantially increase, making it more challenging to explain results to shareholders.
The CECL standards will be effective starting Dec. 15, 2019, for public business entities that are SEC filers, while public business entities that are not SEC filers will have to comply with CECL standards for fiscal years beginning after December 15, 2020. For all other organizations, the CECL standard will be effective for fiscal years beginning after December 15, 2021.
Incurred Loss versus Expected Credit Loss Model
CECL brings some significant changes from practices under FAS-5 and FAS-114, one of which is the move from an incurred loss to an expected credit loss accounting framework.
- Probable recognition threshold: While current incurred loss methods delay recognition of credit losses until it is probable a loss has been incurred, the expected loss model removes the threshold of “probable”, and requires recognition of credit losses when such losses are “expected” (i.e., day-one upfront recognition of credit losses using long-term economic forecasts over the contractual term);
- Increased complexity related to loss forecasting: While current “incurred loss” methods generally apply forecasts over a horizon determined over a loss emergence period, loss estimates under CECL will incorporate historical loss information, current economic conditions, as well as a projected “reasonable and supportable” forecast horizon (with reversion to historical loss information for future periods beyond those that can be reasonably forecast); and
- Additionally, this could put pressure on an institution’s profitability and increase the volatility of its ALLL (Allowance for Loan and Lease Losses) in the short-term.
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CECL Impact
The adoption of CECL has several impacts, and brings with it several challenges. Some of the more notable expected changes and implications are summarized below:
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Lower and more volatile capital ratios
Upon initial adoption, the earlier recognition of credit losses will likely result in larger allowance levels and therefore lower capital ratios, with some commentators estimating a reduction in industry common equity tier 1 ratios by as much as 0.50% once fully phased in.
In addition, companies will experience lower capital levels during periods of strong credit growth, since the higher provisions are booked upfront, before any income is accrued.
Since the forward-looking modeling required by CECL relies on a number of macroeconomic variables, CECL is also likely to introduce greater volatility in provisions, P&L and capital ratios.
To offset the increase in allowances and absorb this greater volatility, companies will likely need additional capital. In addition, to assess the stability of their CECL allowances, it is recommended that companies conduct extensive sensitivity testing on their models, and methodology assumptions.
Product Profitability
Products will likely see an overall reduction in return on equity, particularly for products with longer expected lifetimes (e.g., mortgages, commercial real estate, etc.), and high risk/reward segments (e.g. “revolver” credit card portfolios) since provisions will now be front-loaded before any revenue can be accrued.
Companies will likely respond in a variety of ways:
- Product structuring: Companies may seek to reduce contractual terms for some products (e.g. shorter renewal periods), since companies must only reserve for losses up until the end of the contractual term.
- Pricing: Longer term products will likely become more expensive, and cost may be passed on to borrowers. In addition, as CECL allowances incorporate more risk, there will be a greater incentive for companies to embed more risk sensitivity into their pricing. This may include higher fees and/or incentives to influence payment behavior.
- Securitization and loan sales: For products with longer expected lifetimes (e.g., mortgages), there will now be a greater incentive to securitize and/or sell on loans to investors rather than holding loans on the balance sheet.
Loss forecasting methodology
Since FASB does not prescribe a particular methodology for calculating allowances under CECL, there are multiple methodological decisions to be made and a number of key challenges to be addressed.
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Additional Data/Cost
Due to more complex expected credit loss models, CECL will certainly require more complete and detailed data, and will likely incur additional costs in the process.
- More Data: Additional granularity will be required as macro-level data and other risk factors will need to be analyzed to assess the impact of various credit loss scenarios.
- For most companies, this means capturing and archiving loan-level data to ensure they have the flexibility to access different methodologies, and plan potential capital adjustments.
- Increased Cost: CECL’s reliance on more granular data could introduce new costs and complexities.
- Companies may incur additional costs to support adjustments made to historical loss information to reflect changing economic conditions, including financial modeling, data, and documentation costs.
Data Management
Given the large number of risk and finance data elements CECL will require, new concerns are likely to arise regarding data quality and governance.
- Audited results: Since CECL will have a direct impact on public financial statements, CECL results will be subject to external audit; and
- SOX implications: Additionally, companies should consider Sarbanes-Oxley implications, and establish the necessary controls to ensure compliance.
Increased Disclosure/Transparency
The level of disclosures and transparency will substantially increase under CECL, as any justifications of assumptions, methodology choices, or any adjustments will have to be more quantitative in nature.
In addition to requiring more granular disclosures, CECL will make it significantly more challenging to explain results to shareholders, both internal (board and senior management) and external (auditors, regulators, and investors), and to account for changes in reporting periods.
- Accordingly, management's selection of forecasts or model outcomes (which may be a result of iterative model runs) will need quantitative backing to justify their selection; and
- Peer allowances: Boards should be aware of peer allowances (and their methodologies), especially if a company’s allowances significantly differ from peer institutions, which could occur in situations where a company’s outlook is different to peers or where there are material changes in model assumptions.
Executive Pay Impact
As it relates to executive compensation and corporate governance, company boards should be concerned with how CECL will influence:
Profitability and compensation
In short, CECL will likely have an adverse effect on most profit and return measures, and in a domino effect, income and bonuses could be affected. Since the implementation of CECL requires earlier recognition of credit losses, this will likely increase allowance levels and lower the retained earnings component of equity (i.e., common equity Tier 1 capital.
- Additionally, companies should be aware of how CECL allowance estimates affect company budgets: The FASB and regulators alike have repeatedly emphasized that there is no ‘one size fits all’ approach to methodology selection for estimating allowance levels under CECL – companies may apply different estimation methods to different groups of financial assets. Knowing which methodologies are best suited to the loan portfolio will enable companies to make better decisions regarding capital, which ultimately affects compensation.
Pay-for-performance
With lower and more volatile capital ratios expected under CECL, incentive plan metrics involving profit and return measures (net income, ROE, etc.) will likely be affected, and could also impact incentive plan goals that were previously set for outstanding long-term performance plan cycles.
- Specifically, affected companies will need to address performance goal setting and measurement issues (should CECL be adopted midway through the performance period), to ensure that performance is measured accurately in relation to any goals which are affected; and
- Use of relative measures could help mitigate some of the effects of CECL on incentive plan targets, as most peer institutions will need to comply with the new accounting standard, and will likely experience similar implications.
Recommendations
Given the substantial impact that CECL will have on financial institutions and other companies, incentive pay plans and proxy statement disclosures will likely be subject to increased scrutiny from shareholders and proxy advisory firms in the near future. As a result, companies should:
Consider revisions and adjustments to performance levels, metrics and future performance goals
As it relates to incentive pay plans (particularly multi-year long-term performance periods), companies may need to revise or adjust performance levels and future performance goals to account for circumstances beyond their control (i.e., CECL). Should companies find themselves in this situation, the issue can be addressed in a number of ways:
- Mid-year/Mid-cycle revisions: With mid-cycle adjustments, forecasting issues can be overcome and performance goals can be adjusted to more updated and accurate values. Additionally, the risks of motivational disconnects or retention issues could at least be partially mitigated. However, with this approach, there is a potential sense of “goal posts being moved” and the objective nature of performance goals being compromised, which in turn, could create poor optics for shareholders if goals are paid out despite missing initial targets;
- Additional “make whole”/retention grants: In this approach, participants could earn some incentive payout without compromising the original performance objectives. However, if not communicated thoughtfully, this could create poor optics related to payouts despite missing target performance levels; and
- No mid-cycle revisions, but changes to future cycles and grants: This option carries no risk of performance goals being viewed as subjective or lacking integrity, and is generally used in conjunction with “make whole”/retention grants. Though if previous cycles are not addressed, there could be greater potential for motivational/retention issues.
Have clear communication and detailed disclosure
Given the increased levels of disclosure under CECL, and the subsequent challenges explaining results to shareholders, companies should utilize their proxy statement and corresponding Compensation Discussion and Analysis (“CD&A”) section to outline a clear and organized rationale explaining any pay decisions associated with CECL’s impact on company performance.
- The CD&A is a company’s best opportunity to tell the story of its executive compensation decision making and rationale, and can go a long way towards gaining shareholder approval for the Say-on-Pay vote. Accordingly, a company’s CD&A should:
- Provide an executive summary disclosing the rationale and decision-making behind any changes in pay levels or performance goals as it relates to CECL. This should tie into the context of business strategy, explaining compensation philosophy, as well as the role of the Compensation Committee, management and any outside advisors in determining pay;
- Differentiate clearly between pay opportunities and actual payouts, as well as discuss business achievements and business challenges associated with CECL, and how they affected results; and
- Be written in “plain English” that shareholders can understand, avoiding legalese, and approaching the discussion from a viewpoint of a shareholder.
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