As we approach Q1 quarter-end reporting, many financial institutions are preparing to report on their current expected credit losses (CECL) within their financials (i.e., Securities and Exchange Commission 10-Q) for the first time. In response to the economic conditions surrounding the COVID-19 pandemic, the Coronavirus Aid, Relief, and Economic Security (CARES) Act1 was signed into law and provides a stimulus package, which includes a provision (Section 4014) that would allow certain insured depository institutions, bank holding companies, and their affiliates (hereafter to be referred to as financial institutions) to delay the compliance with the CECL accounting standards until Dec. 31, 2020, or the end of the COVID-19 National Emergency (whichever comes first). The inherent uncertainty of the end of the COVID-19 National Emergency makes adoption of this delay additionally challenging.
The CARES Act also modifies another factor that impacts the CECL estimation process for 2020. Section 4013 of the CARES Act states that “for the period beginning on March 1, 2020 and ending on the earlier of December 31, 2020, or the date that is 60 days after the date on which the national emergency concerning the novel coronavirus disease (COVID-19) outbreak….terminates” a financial institution may elect to “suspend the requirements under United States generally accepted accounting principles for loan modifications related to the coronavirus disease 2019 (COVID–19) pandemic that would otherwise be categorized as a troubled debt restructuring” and “suspend any determination of a loan modified as a result of the effects of the coronavirus disease 2019 (COVID–19) pandemic as being a troubled debt restructuring, including impairment for accounting purposes.”
A troubled debt restructuring (TDR) should be modeled for CECL purposes if it is “reasonably expected” over the life of the loan. While the definition of a troubled debt restructuring did not change under CECL, the above suspension election of TDR requirements will impact the CECL estimates.
On April 3rd, the Office of the Chief Accountant (OCA) of the U.S. Securities and Exchange Commission (SEC) indicated that they “would not object to the conclusion that this (i.e., Sections 4013 and 4014 of the CARES Act) is in accordance with GAAP for the periods for which such elections are available2.” The OCA is actively working with the FASB on COVID-19 impacts and we expect to see further guidance from FASB and regulatory bodies on the specifics of the actual implementation of the delay in the coming weeks. On a related note, the SEC issued an order3 allowing certain public filers an additional 45 days to submit Form 10-Qs and other required disclosure reports due to COVID-19 related circumstances.
Regulators have agreed that financial institutions adopting CECL this year can delay the impact of CECL on regulatory capital for two years (12 CFR Part 2174), in addition to the final rule5 (from February 2019), which allowed financial institutions to phase-in any potential impact to regulatory capital over three years (i.e., a five-year transition, in total). However, financial institutions that have elected CECL still have the option to elect the three-year transition. The modified regulation enables financial institutions to assume more risk in lending to individuals and/or businesses and grant more loans overall, while maintaining the desired level of quality of regulatory capital during these uncertain economic times. Additionally, the CARES Act grants financial institutions the flexibility to inject more liquidity into the U.S. economy.
Implications as a Result of COVID-19
For financial institutions that have already implemented CECL during the first few months of the year, the call for deferment of CECL may be too late. Financial institutions have spent the last several years at considerable costs preparing for CECL (i.e., running systems in parallel, updating methodology and documentation, etc.), and to revert back to the Incurred Loss method could now cost more money, time and energy at a time when most forecasting teams at financial institutions are working remotely. For instance, model documentation, assumptions and methodologies will have to be revisited as well as process documentation, policies and the overall internal control environment. Additionally, following the Incurred Loss method at this point may not help to avoid a potentially significant reduction to Common Equity Tier 1 (CET1) capital and could be worse without the phase-in offered to CECL adopters discussed above.
With the COVID-19 pandemic, reserves for credit losses (whether utilizing CECL or the Incurred Loss method) in the coming quarters will likely increase if the financial services industry has to come to grips with another economic downturn.
What Financial Institutions Can Expect
The use of qualitative/imprecision overlays by management may increase due to certain model limitations since actual losses will not have occurred in full for the portfolio by the time of the next reporting period (Q2 2020). A multitude of evidence will be available between the quarter-end and filing date for consideration. Trying to incorporate potential COVID-19 economic impacts into the financial institutions’ specific portfolios, as well as offsetting the impact of the government led recovery and stimulus packages, could make it more challenging to estimate the allowance. When using qualitative/imprecision overlays, it is important that a structured and repeatable process is in place, where adjustments are well supported with rationale and verifiable metrics.
The macroeconomic data used in the reasonable and supportable forecast period will be critical during this time. Financial Institutions will need to forecast metrics such as the unemployment rate and other statistically significant macroeconomic variables to estimate their allowance for credit losses. In order to accomplish this during times of such uncertainty, many financial institutions in the industry will be deploying robust challenger models with sensitivity analysis to incorporate multiple scenarios of COVID-19 economic impacts.
Given the amount of variance resulting from the COVID-19 pandemic and the federal government’s response with the CARES Act, model governance will be a key consideration in this transitory period. If delaying CECL implementation, models that were retired under the Incurred Loss methodology will now need to be reactivated and approved for use in a controlled environment. Another key consideration would be data infrastructure that was changed for CECL models; reverting to the old Incurred Loss data architecture could result in incomplete and inaccurate data sourcing and transformation.
Robust and demonstrable challenge through management review controls will be increasingly important for the upcoming credit loss forecast estimates, which will require significant management judgement. Regulators and auditors are well aware of the imprecision of loss forecasts and will expect them to change as new information about the spread of COVID-19 comes to light. The demonstration of “credible challenge” and ability to explain changes to the loss allowance estimate and any key underlying assumptions will be critical.