What is CECL (Current Expected Credit Loss)?
CECL, or Current Expected Credit Loss, is a new accounting model the Financial Accounting Standards Board (FASB) have issued that changes how financial organizations account for credit losses. The FASB have changed how banks estimate their losses in the allowance for land and lease losses (ALLL) calculation. The introduction of the new standard will mean that the probable loss threshold is removed and a lifetime credit loss allowance is required on day one of each exposure. By December 2019 that will be in place rather than the current rules that require an allowance for credit losses only expected to incur over the next 12 months.
Why Does It Matter?
The 2019 deadline is approaching and implementing CECL will be more complex than many institutions realize. A management framework will be closely scrutinized by both auditors and regulators who will want to see evidence of the management controls and data governance, to assure the transparency and accuracy of the results. Institutions will need to consider how best to achieve this, as part of delivering a complex and challenging CECL implementation project.
The new standard will not only affect how banks calculate credit loss reserves, but also how organizations fundamentally manage their ALLL and organizational processes for both finance and risk management. The scope of these changes can be substantial depending on the complexity of the balance sheet. The changes required by CECL require a much deeper level of modeling, analysis and reporting than what has previously been required. And these changes are significant in terms of how banks will need to manage risk and financial data, build their analytic platforms and share information between departments.
The Challenges of CECL
The advent of Current Expected Credit Loss reporting as an additional accounting requirement for US credit lending institutions is widely recognized as a significant technical, operational and compliance challenge for many institutions. The combination of complex modelling, the use of large and changing volumes of portfolio and market data, and the need for consistent, accurate and auditable results means that institutions are already under pressure to implement CECL, even with an implementation date of December 2019.
Key challenges for CECL will be:
- Data growth – to correctly account for the expected losses the new Current Expected Credit Loss model will bring substantial greater data requirements and changes to methodologies.
- Change in framework – one of the most significant changes is the move from an incurred loss to an expected credit loss accounting framework.
- Increased transparency – CECL will also require increased transparency in the application of assumptions and in the disclosures around the allowance estimate.
Risk Management and Governance Issues for CECL
The top five risk management and governance issues of implementing CECL are:
1. Extensive use of Uncontrolled Spreadsheets
Spreadsheets that are not controlled, tested or validated increase the likelihood of error, missing data and flaws that generate inaccurate results as well as creating audit issues.
2. Reliance on External Data Sources
Arrange of external data sources will be regularly updated to keep models current. If this data is embedded in a CECL spreadsheet model, these data links have the potential for errors, give risk to accuracy and transparency of data.
3. Widespread use of Integrated Spreadsheets, Macros and Formulas
Errors, omissions and changes to these can present risks than can materially impact the accuracy and auditability of the final results.
4. Business, Reputational and Regulatory Impact of Errors
The use of uncontrolled spreadsheets, with their inherent risks, could generate errors that could drive greater volatility, or even the need to re-state earnings, potentially causing a range of business, reputational and regulatory headaches that institutions would want to avoid.
5. Audit and Regulatory Risk
Given the complexity of calculating CECL results, demonstrating this this governance and control to external stakeholders, in a timely and cost effective fashion will be challenging. The cost of achieving this manually would be prohibitive.
How Prepare for CECL
1. Identify the CECL spreadsheets
These spreadsheets will be located in different departments, business units and even countries. Initially at least, as institutions start their CECL journey, there may be different versions, formats and definitions. This provides ample scope for the emergence of spreadsheet risk further down the implantation and reporting path.
2. Risk Assess those spreadsheets
Having a systematic risk assessment model for Current Expected Credit Loss allows people across the business to agree objectively which are the spreadsheets that require the closest scrutiny. This can form the basis of an effective CECL project implementation model, as well as serving to develop the risk management, audit and governance framework that institutions will have to adhere to when the standard comes into force in 2019.
It also ensures that the risk management focus is targeted at the right areas, rather than having the effort dissipated through assessing too many of the wrong spreadsheets.
3. Monitor and audit CECL spreadsheets
The final stage is to closely monitor your key CECL spreadsheets, to identify changes to them and their potential impact to the results and the wider business. It is important that changes to the spreadsheets – to formulas, data sources, individual worksheets and macros for example – can be easily identified, as they can have a material impact on the final CECL results, as well as the project implementation. Equally the absence of approved changes need to be easily identified, to ensure that the project remains on track.
How Spreadsheets Will Be Key to CECL
Given the current timescales and the challenge of developing the new models – coupled with the difficulties of making changes to complex enterprise systems – anecdotal evidence suggests that banking and lending institutions will have little option but to resort to the use of spreadsheet models. To calculate CECL, these spreadsheets are likely have complex calculations, spread across a number of workbooks and dependent on data from external sources and applications. This spreadsheet modelling gives rise to significant spreadsheet risk to the CECL calculation process.
Due to the complexity of CECL calculations, and the likely widespread use of spreadsheets to deliver them, institutions will likely need to invest in a spreadsheet management platform to identify and control the relevant spreadsheets. All spreadsheets included in this framework are monitored to ensure transparency around the changes being made to each of the spreadsheet models to ensure no errors or omissions occur that, if undetected, would compromise the CECL data, models and final results.
This approach allows institutions to harness the power, flexibility, and familiarity of spreadsheets to meet the deadline, while also ensuring they meet the governance and audit standards required. It helps reduce the implementation risks and timescales of their CECL project, while also reducing the scope for reputational, commercial and regulatory issues that may emerge from a complex set of requirements.