On December 21, the OCC, FDIC and the Fed Board of Governors approved a final rule modifying their regulatory capital rules and providing a phase-in period of three years of the day-one regulatory capital effects of CECL. The final rule will take effect April 1, 2019.
Recall CECL requires that institutions account for the expected credit loss over the life of a loan at origination/acquisition and sets aside capital for expected future losses. CECL replaces the incurred loss standard, where institutions account for credit losses expected in the next 12 months.
CECL replaces the incurred loss standard, where financial institutions recognize credit loss when a financial asset reaches a probable threshold of loss. This standard requires that institutions account for credit losses expected in the next 12 months.
In practice, this means that institutions often calculate the annual charge-off rates using historical data for a specific loan pool and adjust this rate for the current credit environment. Multiplying the adjusted rate by the balance of the loan pool yields the 12-month, credit-loss amount used in allowed loan and lease loss reserves (ALLL). This amount is often referred to as the ASC 450 or FAS 5 ALLL. The figure below summarizes the incurred loss standard.
The incurred loss standard delays recognition of credit loss until loss is imminent. Therefore, the standard is criticized for contributing to insufficiencies in bank reserves during the 2008-2009 recession. Furthermore, the standard is criticized for failing to provide adequate credit-risk information to investors. In other words, the premise is under the incurred loss standard, neither banks nor investors had sufficient information to accurately account for the credit exposure of a banks’ balance sheets – until it was too late.
In contrast to current methods, CECL requires that institutions recognize each asset’s expected lifetime credit loss immediately. Whereas the existing standard for loss accounting measures the current loss on a portfolio using backward-looking methodologies, the new standard measures the current risk of the portfolio using forward-looking methodologies.
Note the changes in the figure below. Rather than using historic annual charge-off rates, CECL requires banks to consider historic lifetime charge-off rates. Furthermore, lifetime charge-off rates must be adjusted for the current and future credit environments. Multiplying this life-time adjusted rate by the loan pool balance yields the total expected credit loss over the lifetime of a bank’s financial assets as the new ALLL.
Adjusting historic lifetime charge-off experience for the future credit environment requires forecasting. First, institutions need to determine which economic variables correlate highly with their loan loss history. Then, institutions can use proprietary forecasts or use publicly available data from the various government agencies.
Summary of the Final Rule
Implementation of CECL will likely affect banks’ retained earnings, DTAs and allowances, and thus, it will also affect regulatory capital ratios. Retained earnings and DTAs are key components of a bank’s common equity tier 1 (CET1) capital, and ALLL is included in a bank’s tier 2 capital.Therefore, the agencies amended the capital rule to identify which credit loss allowances under CECL would be eligible for inclusion in a bank’s regulatory capital. The rule revises the agencies’ regulatory capture rule, stress testing rules, and regulatory disclosure requirements to reflect CECL. Additionally, the final rule provides banking organizations the option to phase-in the adverse effects on regulatory capital that may result from adopting CECL.