By Ron Meyer, Senior Business Advisor for Capitalstream, Linedata
Banks are beginning to prepare for the biggest accounting change in living memory. Because the current system of financial reporting was too slow to recognize losses on loan and debt securities during the financial crisis, the global accounting framework for debt instruments is being reformed. The International Accounting Standards Board and the Financial Accounting Standards Board are introdu-cing new accounting rules that will fundamentally change how banks reserve for such losses. The idea is that more timely loss recognition will make it easier to judge how risky a banks underlying assets are.
Both the FASB’s Current Expected Credit Loss Model (CECL) and the IASB’s IFR9 credit impairment model are designed to make the recognition of credit losses more responsive to changes in the credit lifecycle. However, while IFRS9 utilizes a dual measurement model requiring entities to recognize credit losses on a 12-month or li-fetime basis based on credit risk direction, CECL requires banks to estimate credit losses over the lifetime of the loan, from the point the loan is made or a debt security is acquired. Where these standards overlap is they require banks to use historical data, current economic conditions and reasonable forecasts to measure expected credit losses.
The financial modelling this will involve is going to de-mand much more granularity than the more generic mo-dels banks have been using to calculate loan loss provi-sions to date. And data supporting CECL and IFRS9 will be subject to scrutiny, due to its impact on financial repor-ting. Consequently, data quality, availability and collec-tion is going to have to be the focus of implementation. Banks are going to need systems that collect quality data at the point of origination, keep it in one place and have integrated reporting facilities.
The problem is, few banks have the necessary digital solu-tions and data structure, even after investing in systems to comply with stress testing under the Basel III global framework on bank capital adequacy. Nor do they have the data management and risk modelling skills they’re going to need to comply with CECL’s onerous qualitative and quantitative disclosure requirements.
Estimating lifetime losses is largely dependent on subjec-tive assumptions about future business conditions. So banks are going to have to think hard about the macroe-conomic data they use to reflect the state of the econo-my, and use scenario and sensitivity analysis to capture expected losses during downturns – and justify why their assumptions may differ from other banks. When even banks with sophisticated approaches to regulatory capital are going to need to upgrade to more advanced models and analytics, it’s hardly surprising that smaller banks fear the data demands will overwhelm them.
There are a handful off-the-shelf systems that can effi-ciently monitor and analyze credit risk within loan and lease portfolios. These systems are capable of capturing borrower and related party information as well as de-tailed financial data that banks are going to need to ana-lyze the financial strengths and weaknesses of debtors under these new impairment standards while providing historical data analysis and ongoing account monitoring and risk management activities.
It remains to be seen whether CECL will survive the new administration’s financial regulatory reforms. Some lawmakers have expressed concerns that higher loan-loss reserves will force community banks to raise consumer prices and reduce the availability of credit. Instead, they advocate that CECL should be based on historical losses and tangible data sources instead of complex modeling. That said, it’s highly likely that the US will at least get some flavor of IFRS9, given that it comes into force in January 2018, two years before public SEC filing institu-tions have to comply with CECL.
Being able to show that your customers are low credit risks is going to be critical in this world of big data and regulatory technology. Banks which utilize legacy systems may be at a tremendous disadvantage, considering that accounting for non-performing loans is at the core of fractional-reserve banking, and that CECL and IFRS9 are therefore going to have a huge impact on auditing costs, deployable bank capital and pricing. So, while the right solution might be a big investment, it’s an obvious choice given that these accounting standards represent such a significant departure from industry practice. Or looking at it another way, it’s an opportunity for banks to im-prove their ability to underwrite and price their loans.