By Roy Urrico
A new accounting standard, which uses an “expected loss” measurement for the recognition of credit losses, goes into effect January 2023 and is already changing how credit unions plan to set up future bookkeeping practices. Fintech and security company NXTsoft is helping credit unions prepare for dealing with this new approach.
The Financial Accounting Standards Board (FASB) issued the current expected credit losses methodology (CECL) in June 2016. Financial institutions may adopt the CECL standard sooner than the 2023 deadline.
CUNA reported CECL’s effect on credit unions both from a compliance standpoint, in which credit unions have listed it as a top challenge, and on the organization’s financial standing.
Nerd alert, accounting terminology ahead. According to the NCUA, CECL will cover:
· All financial instruments carried at amortized cost, including loans held for investment, net investment in leases, held-to-maturity (HTM) debt securities, trade and reinsurance receivables, receivables that relate to repurchase agreements and securities lending agreements.
· Off-balance-sheet credit exposures not accounted for as insurance, including loan commitments, standby letters of credit and financial guarantees.
· The accounting for credit losses on available-for-sale debt securities, including lending arrangements that meet the definition of debt securities under generally accepted accounting principles (GAAP).
Some elements of calculating expected losses will remain the same: management’s responsibility to choose the most appropriate estimation method for the credit union for evaluating credit risk; scalability to a credit union’s asset size and complexity of its financial assets; requirement to recognize credit losses’ inclusion of historical loss averages; incorporation of qualitative factors; and determination of policies for nonaccrual of interest and charge-offs.
CECL will not cover trading assets, loans held for sale, financial assets that selected the fair value option, and loans and receivables between entities under common control.
Preparing for CECL with Help
Most credit unions must switch by January 2023 from the current allowance for loan and lease losses (ALLL method) and start reserving for loan losses based on the CECL calculations.
The NCUA recommended credit unions should begin preparing now to implement the standard: “Boards of directors and senior management should familiarize themselves with CECL to assess how it differs from the credit union’s existing incurred loss model. Once familiar with the standard, they should evaluate different allowance estimation methods to determine which is appropriate, and plan for the potential impact on regulatory net worth.”
OmniLytics, a division of Birmingham, Ala.-based NXTsoft (formerly known as FIMAC Solutions until purchased by NXTsoft in 2018) offers a solution, CECL Services, which is a standalone product that clients can purchase.
“The overall purpose of CECL Services is to enable financial institutions to meet the largest change in loan loss reserve calculations in decades,” John Anton, OmniLytics senior vice president, said. “We like to think of CECL Services as being as close to outsourcing the CECL calculations as possible for financial institutions,” explained Dave Hynds, product manager, CECL Services.
CECL Services works by pulling the loan balances and loss history data for every credit union directly from the NCUA. NXTsoft then works with the client in an online meeting to determine the settings in the CECL Services model to use (e.g., to use the all periods or the most recent loss rate as the starting point, or how much to skew toward the peer group’s loss rates or alternative loss timeframe). These settings, according to NXTsoft, generally stay fairly constant from quarter to quarter.
“Adjustments to fine tune the model are encouraged, wild swings in the settings are discouraged,” said Anton. “In addition, at the initial meeting we usually address if we need to change the timeframe of data that we are utilizing and/or if we need to cap the asset size of the peer group data that we are utilizing.” The default setting for the data timeframe is to start with March 2007 call report data. The timeframe although chosen purposely, as it includes the downturn from the Great Recession years of 2008-2009, is customizable.
“One of the major changes involved in switching to the CECL methodology is to look at loss rates on a ‘life of loan’ basis, instead of the previously acceptable annualized method,” Anton said. In order to do this, NXTsoft’s CECL Services model utilizes a life of loan figure for each different type of loan in the portfolio. Anton noted, NXTsoft has calculated the life of loan for numerous institutions in its 30 years of asset liability management (ALM) modeling and consulting, and uses these lifetimes as the initial settings in the CECL Services model. “However, credit unions are free to provide their own lifetimes for each different type of loan, and can utilize their own figures in the CECL Services model calculations.”
How Would Credit Unions Use CECL Services?
Once the client settles on the initial settings, the NXTsoft staff prepares the formal narrative report for the quarter. CECL Services delivers the report quarterly. It consists of a 12-14 page report designed for sharing with regulators, auditors and boards of directors. “It contains a narrative description of the CECL process and acceptable practices, as well as a description of the settings chosen by the credit union and the results of the calculations,” Hynds said. In addition, each quarter NXTsoft requests clients respond to a list of 10 questions, known as the “Q Factors” or “Qualitative Factors.” Clients’ responses to those question helps in the preparation of the quarterly CECL Services report and impacts the results.
“During the preparation of the report, NXTsoft’s analysts are watching for any anomalies in the data and/or results and are proactively looking to make suggestions for fine tuning the settings of the model. This has been known as ‘An analyst with each report,’” Anton pointed out.
Included in the report is a synopsis of calculations related to each loan type, known as the Impact Report. CECL Services provides a reserve for loan losses calculation that follows the overall premise of CECL, which is to calculate the credit union’s historic life of loan loss rates for each loan type, and then to adjust from that point by looking out 12-24 months into the future. Anton pointed out the process allows customization by the client in regards to the loss rate to use as starting point, historical data starting point, peer group asset size, skewing toward peer and alternative time period results, and forward-looking expectations.
“It is, of course, recommended that credit unions select their modeling methodology/vendor in the near future so that the CECL calculations can be run in parallel with their current allowance for loan ALLL calculations,” Hynds suggested. “By doing so, credit unions will be able to predict the changes to their loan loss reserves required on December 31, 2022/January 1, 2023.” He added, this will be imperative for institutions, especially those making sizeable reserves changes.
NXTsoft provides pre-purchase estimates of CECL reserve with a free CECL report. OmniLytics’ ALM, Fixed Income Accounting, Credit Stress Analytics and CECL Services products are available as separate products or bundled.