- The earlier approach of an incurred loss model to provide for credit losses was considered to be restrictive. It delayed the recognition of a loss provision unless it is probable that a loss has been incurred
- The new standard requires all organizations to provide for expected credit losses based on historical experience, current conditions and reasonable and supportable forecasts
- There is no single method prescribed by the standard and the FASB expects the complexity of the model to be aligned with the complexity of the organization’s business model and processes
- The estimates have to be based on the expected life of the asset and should be assessed collectively based on similar risk parameters
- Additional disclosures are required for credit quality indicators by Vintage (year of origination)
- A new impairment model for AFS debt securities
- Valuation of PCD assets at initial recognition
Challenges Lie Ahead
Not only are these changes expected to alter the month end and quarter end book closure processes, these will also impact the profitability numbers published by organizations (mostly financial institutions) and will undergo higher scrutiny with respect to what assumptions have been taken into account for the estimation of Allowance for Loan and Lease Losses (ALLL).
Combine this with intersecting regulatory requirements from CCAR, DFAST and BIS and the understanding of credit risk a financial institution faces complicates even further. There would be multiple interpretations of how credit risk is viewed by the bank for different regulations and even worse, how it is understood and computed can differ by the various divisions in the same bank.
When Life Hands you Lemons…
Make lemonade...or so the saying goes! But in looking at this from a different perspective, I see the changes as an opportunity to help banks and the entire financial services industry to change and evolve for the better. Some of the benefits I see include:
- Forcing the Risk and Finance teams within the organization to start aligning with each other and communicate in a language understood by both – leading to:
- Data convergence – how it is captured, processed and reported
- Model convergence – how risk parameters are derived and consumed
- Changes in organization structures to support
- This standard will necessitate an auditor to investigate more into the assumptions made for current conditions and reasonable supportable forecasts and would compare with similar assumptions made at peer organizations – leading to more transparency in peer groups and unearthing of black box models
- Most internal ratings-based (IRB) banks would prefer to extend and adjust their existing credit risk models to cover CECL expectations leading them to expose their models to the auditor, considering that the assumptions would need to pass the test of reasonableness. To stay relevant in these conditions, these models and associated technology applications would also need to be transparent and auditable.
- Considering there is no single prescriptive model for CECL, it is more likely that Tier 2 institutions would look towards enhancing the incurred loss models presently used and adjust them to reasonable supportable forecasts. This is a solution that can work in the interim, but it ultimately leads the organization to look at tactical solutions that may not pass an auditor’s test or scale up to future needs. Eventually most institutions will need to work towards a more strategic solution that solves the Risk and Finance intersections more holistically.
- Institutions that are already on the path of an integrated risk and finance model will stand to benefit the most. With the issuance of a discussion paper by BIS on regulatory treatment of accounting provisions, other regulators can also look at options to converge these models and assess credit risk with similar objectives to arrive at a standard way of computing these provisions either for financial reporting or regulatory reporting. The cost of compliance with tighter regulations is weighing down the financial services industry and continued divergence and regulatory changes will add to the burden; but it can ultimately lead to standardization of data, models, processes and systems that benefit the entire financial institution.
All parties involved, from the regulators to the banks and even including the vendors that support financial institutions, need to evolve and think out of the box to what the future will likely be and work towards holistic solutions for the same. Apart from what I’ve outlined above there can be more reasons for evolution, such as convergence with treasury operations for valuations and hedge accounting given that standards on the same are still evolving.
Geetika Chopra is a product manager with Oracle Financial Services Analytical Applications leading the solution for IFRS Compliance. She can be reached at geetika.x.chopra AT oracle.com.