April 2, 2019
You have completed your Current Expected Credit Loss (CECL) models. Your team initiated the validation process, and you are even a month away from a “parallel run” testing. So, you are in the home-stretch — right?
Not even close!
Your bank still has a boatload of tasks to do and not a whole lot of time to do it. From auditors and regulators, to the board of directors and even key staff people, there is a large group of stakeholders closely following your institution that should be “in the mix”, so that they are acquainted with the firm’s CECL transition, the financial impact, as well as the controls enacted to to ensure accuracy.
Given the scale and importance of the CECL transition and the limited time before implementation for some banks, all financial institutions should take the time to review the current state of the CECL transition, confirm that your strategy is sufficient to achieve compliance at implementation date, and buckle down on the CECL governance framework.
As part of a strong governance plan, financial institutions need an active CECL governance committee. While this committee might have been installed at the commencement of the CECL transition exercise, the committee should now turn its attention to the effectiveness of the parallel runs, the engagement of internal and external audit, the preparedness of the reporting function, and most importantly, the integration of CECL across the firm.
The time to perform parallel runs is ticking away. At the early planning stages, most banks were expecting to perform parallel runs for a full four quarter cycle, however, this will likely be reduced as financial institutions continue to rush to get their models through the validation process. Shorter parallel runs may not provide sufficient data to capture any abnormalities in the calculation of the allowance for loan and lease losses (ALLL) within the CECL framework. This could lead to less than accurate ALLL reporting, potentially causing reporting adjustments, which chisels away at investor and regulator confidence.
An understanding of the CECL process, models, input, and output across an enterprise is essential to effective implementation. Transparent communication with boards, regulators, and the investor community will benefit a financial institution by increasing stakeholder confidence. The old adage, an ounce of prevention, is worth a pound of cure, rings true here. The more information stakeholders have in advance of implementation, the more confidence they will have in the financial institution. Financial institutions need to manage their messaging and disclosures, by working with legal and financial advisors on what to say and how to say it, to effectively communicate without getting overly technical.
Management teams must have the ability to explain a CECL transformation, the use of models in ALLL calculation, and controls put in place to ensure an appropriate result. Moreover, management should have a process for a ‘reality check’ to verify that the model results are within expectations.
One of the significant issues facing banks in the CECL adoption process likely will be explaining a significant increase in ALLL. The one-time provision on adoption of CECL may well result in a 20 percent to 40 percent or more increase in the ALLL for many financial institutions. The increase likely will come from establishing a life of loan loss estimate and will have to be explained carefully to a bank’s shareholders and stakeholders, lest there be concern about a new wave of higher risk lending.
Financial institutions need to welcome their external auditors into the CECL fold sooner rather than later. Engaging the auditors early in the process should help prevent the occurrence of misunderstandings of models or processes that could lead to identification of material weaknesses. Last minute feedback from auditors or regulators, as well as the second or third lines of defense could lead to control deficiencies.
Firms should pay particular attention to their investor base, as an increase in allowance as a result of CECL will likely impact one of the key numbers of investor focus, net income. Clients should begin to prepare the communication and disclosure components of CECL sooner rather than later. Investors should be offered a CECL education, prior to implementation so that they not only understand CECL’s impact on results but understand steps the firm has put into place to ensure the proper implementation and correct estimates. This will yield an increase in investor confidence, which may benefit the firm well beyond 2020.
Properly developed internal controls for the entire CECL process from modeling to reporting should be a requisite of every CECL transformation. To that end, controls should be installed to ensure that the CECL model, the ALLL process and the data used are vetted, surveyed for deficiencies and inaccuracies on a continuous basis.
If your financial institution is public, these controls are part of your Sarbanes-Oxley compliance process.
If history tells us anything, this transition, like many other of the same ilk, will not be a straight sprint to the finish line but will include many twists and turns. To assist our clients in navigating through any such twists and turns that will undoubtedly appear, Ankura developed a CECL Governance and Readiness Assessment in which our team of experts will review the CECL transition process and governance framework to identify gaps and concerns, and provide recommended and/or required actions needed to enhance controls, reduce transition risk, and to remove potential delays/errors in the CECL transformation and validation process that may lead to costly and disruptive last-minute issues.