With the Financial AccountingStandards Board announcing another delay in the release of itsfinal guidance on the Current Expected Credit Lossmodel, it may be tempting to put the changing guidance andeffect it will have on allowance levels in the back of your mind.And you wouldn't necessarily be wrong. The CECL guidance isimpactful, certainly, but it's not cause for panic, and thisadditional delay in the finalized guidance only underscores thatpoint.

However, delay or no delay, the final accounting standard iscoming down the pipeline eventually. And it's rare to seeregulatory changes with such a direct effect on the allowance inthe way CECL is expected to. Regardless of when the proposal isfinalized, there is a clear benefit to thinking proactivelytoday about how the CECL guidance might affect your creditunion and your credit union's allowance for loan and lease lossescalculation.

Currently, institutions calculate the ALLL based onwell-established accounting and regulatory standards that have hadonly minor changes and updates over the past several years. Whilethe exact CECL requirements have not been finalized, CECL willfundamentally change the loan loss reserve calculation and likelyhave implications across day-to-day operations for the creditdepartment.

So why exactly are the standards being changed? A criticism ofthe existing “incurred loss” ALLL standards is that they arebackward-looking in that they rely primarily on historicalinformation. Currently, institutions recognize credit losses onlyonce they are considered “probable” and the losses can be estimated(primarily utilizing past loss experience). This creates a “lag” inhow losses are reflected in the ALLL calculation. This issue wasexposed during the financial crisis, as this delay in lossrecognition meant reserves were insufficient to cover institutions'growing losses as credit deterioration accelerated. The proposedCECL model suggests forward-looking analysis and looks at the lifeof the loan, instead of a single year. The objective is thatinstitutions would account for and therefore reserve for lossesbased on “possible” estimates, no longer just “probable” ones.

What's not made explicitly clear in the initial CECL guidance ishow exactly life-of-loan losses can be defensibly predicted usinghistorical and qualitative factors. For many credit unions,particularly smaller institutions, historicalloss and loan data may not have been archived or might beinaccessible when it's needed for a CECL calculation.

Another perceived pain point for credit unions is the possibleincrease to loan loss reserves that might occur under CECL.It's important to note that, since the model isn't finalized, anincrease in allowance levels isn't guaranteed to occur. However, inthe latest of a series of polls conducted by Sageworks, we've found that morebanking and credit union professionals than ever before areexpecting a 10 to 50% increase in their institution's ALLL.

As mentioned, FASB was expected to release the final standardsthis year, but they've updated that timeframe to the first quarterof next year. Assuming that timeframe holds, we'd expect to see animplementation timeline of three to four years after the accountingstandards are finalized, depending on the individual institution aswell as the governance and policy issued by the NCUA. Again, thisis not something to panic about, and an important point tocommunicate to a credit union's leadership is exact requirementsare still unknown.

However, there are certainly things that your credit unioncan do now toprepare and get ahead of the curve. The best way to prepare forCECL is to proactively gather loan-level data for the portfolio.This would entail collecting and storing data such as a loanbalance, segmentation for the loan, risk rating, charge-offs andrecoveries associated with the loan (partial and full), as well asloan duration. Building up this historical archive of detailed datawill give credit unions the flexibility and resources necessary toadjust their models and use data that's representative of their owninstitution.

There's little doubt that back-end processes for credit unions'ALLL calculations will change over the next several years. Theright steps now are communicating the expected changes andtimeframes to the credit union's leadership and beginning toprepare data and management information systems to accommodate thechanges.

Tim McPeak is an executive risk management consultant forSageworks. He can be reached at 919-851-7474or [email protected].