May 21, 2019
Ankura recently hosted a round table discussion with several of its financial services subject matter experts on the most pressing risk-related topics facing banks and financial institutions.
David W. Giesen, Senior Managing Director with Ankura and its predecessor group for 17 years and a former investment banker.
Steve Picarillo, Managing Director, Ankura’s financial institutions risk advisory services lead; former director at a global management consulting firm and lead financial institutions risk analyst at two major rating firms.
Matthew Romano, Senior Director and accounting support expert at Ankura; former CFO of a consumer bank and a division of a global insurance agency.
Jay Wittman, Senior Director and former CFO and COO of a $1.1 billion community and regional bank in the Midwest; helped lead a three-fold expansion of the bank while serving as CFO.
Q: What do your clients see as their most immediate risk related topic?
Steve: CECL. Most banks are still struggling with some aspects of their CECL transformation and implementation.
Q: With CECL quickly approaching, why are banks still struggling?
Dave: Fear. Some banks are just hoping it will go away. It won’t! Others are waiting for more concrete guidance while others are hoping their accountants or regulators will provide them with an “easy” button.
Steve: I agree. The standard lacks a “how-to” set of instructions and is much more complex than perhaps accounting standards setters led us to believe. There’s also the need to redesign the model validation process, a lack of resources, and an inability of many bank’s senior management teams and boards to fully grasp the meaning, scale, and importance of CECL.
Matt: It’s a mindset change. Most bankers don’t look at loans quite this way. Many financial executives may be good accountants, for example, but they don’t fully understand credit. And vice versa. We talk to bank executives and they grasp some of this, but the first question they’ll face is, “what are you going to do with what you learned?”
Jay: Bankers have to self-educate. They must understand that they’ll have to adapt and so the question is how to best get the information you need and, where to spend your time in a way that is most productive.
Q: So where are we in the process?
Steve: Banks adopting in 2020 should be grappling with validation and parallel runs. Accurate and comprehensive CECL model validation has become a key concern for financial institutions, their regulators, and auditors. Indeed, a proper CECL validation will look at everything, from the model algorithms to forecast periods, data assumptions, environments, etc.
Jay: Many institutions, especially smaller banking entities, do not have the resources to handle installation, defense, and integration. The skill set required for CECL validation is larger than that of other model validations.
Steve: The model teams should be able to strike a balance between statistical accuracy and the accounting aspects of CECL, which may present certain challenges, as traditional modeling teams are typically inclined to quantitative analysis and prefer the statistical approach to modeling. With a small pool of qualified resources, CECL model validators are increasingly more difficult to find and, as the implementation dates approach, the pool of available resources will undoubtably evaporate.
Another concern that we have is the firm’s ability to socialize CECL across the entity. An understanding of the CECL process, models, input, and output across an enterprise is essential to effective implementation. Timely and transparent communication with boards, regulators, and the investor community will benefit a financial institution by increasing stakeholder confidence.
Dave: Related to this is explaining the likely significant increase in ALLL. Ankura expects that the one-time provision on adoption of CECL may well result in a 20 percent to 40 percent or more increase in the ALLLs for many financial institutions. This increase will be attributed to establishing a life of loan loss estimate and must be explained carefully to a bank’s shareholders and stakeholders, lest there be concern about a new wave of higher risk lending.
Matt: We believe that, to maximize the benefit of CECL, banks should leverage the CECL data and insights across the entity. For example, adjusting pricing, loan offerings, and investment decisions based on the CECL impact (ALLLs). Looking at CECL as more than just a regulatory exercise will be a common challenge.
Q: When it comes to risk, what can banks do better?
Jay: While there are many areas to discuss, aligning the firm-wide risk appetite to business strategy continues to be a challenge for both big and small financial services firms. These must be linked to avoid unreasonable or unnecessary financial risk across an enterprise.
There are several dimensions to interconnecting risk and strategy, however to start, risk and the executive teams must be willing and able to communicate, collaborate, and be nimble.
Steve: Most financial institutions have strong risk management processes. However, many banks fail to obtain an enterprise-wide view of those risks. Consequently, silos develop, which can exacerbate the risk/strategy disconnect.
A bank’s financial and analytical tools must break the silos down. CECL output may be one element of this, but it’s also important to educate people on what it means and develop causes and effects of management action. Banks then must work with leadership to adjust both strategies and tactics as management sees fit. The amalgamation of the outputs on a regular basis is a daunting but necessary step to get a wholistic view of risk and to align risk with strategy. This ultimately needs to be one fluid process.
Q: Do banks need to build new models to get a holistic view of risk?
Dave: Banks are always improving or building new models. But I don’t see a one model approach to identifying and quantify all firm-wide risks. So, for this, most likely no but a lot depends on your model inventory, what they do and say. Banks may need to fill in a few gaps in their model inventory.
Steve: Indeed, a one model approach is not possible, however, leveraging the existing models is the issue here. Many banks have models in house that can both contribute to CECL and provide management risk insight. What’s lacking is aggregating the outputs to provide a robust picture of how and what risks affect the firm. Further, we believe that a dynamic risk measurement program that aligns with strategy must include a robust multi-scenario process. Leveraging the CECL “reasonable and supportable” (R&S) forecasts for a base scenario is a good starting point, as by design, that should be the corporate-wide forecast. Importantly, using the R&S forecast will lead to a consistent economic outlook across the firm. We discussed leveraging CECL in a recent webinar.
Q: After CECL, do you expect any other wholesale changes?
Steve: Yes, there will always be changes in risk and in the financial services industry. The next large transformation is the 2021 phase out of the London Interbank Offered Rate (LIBOR). Regulators have begun the hunt for a replacement benchmark rate, which will result in several replacement rates being used around the world, reconcile the different benchmark rates will be yet another challenge.
As with most similar exercises, the early movers will have a smoother, less costly transition. We recommend banks assess their vulnerabilities and carefully plan their transition strategy. Regulators are beginning to ask about LIBOR readiness and the level of their scrutiny will only increase as 2021 approaches.
For many, this is a sizeable undertaking that consumes operations and legal teams for a long time. New contract terms will need to be negotiated, documents will need updating as most older contracts only include fallback language addressing the short-term absence of the benchmark rate, not the discontinuation of the rate.
To get a head start, treasury professionals may want to be as flexible as possible in their fallback language. Further, banks should look to renegotiate existing contracts to add broad language that gives the bank discretion in selecting an alternative or fallback rate in the event the LIBOR benchmark is substantively discontinued. Banks with LIBOR-based consumer loans will have the most difficult transition, as negotiating countless numbers consumers will both time consuming and arduous.
There are many risks associated with under-preparedness. We see execution, basis, reputation, and litigation risks as chief factors related to the benchmark transition.
Q: Anything else?
Jay: One of the big issues that banks face is threshold crossing. As a bank grows larger and more complex, the existing, perhaps long-practices, simple approaches of a community bank don’t work effectively any more. This is true at certain intervals, such as $500 million and $1 billion. Banks must realize they’re going to be facing challenges that mean a whole lot more detail in what they do and that they’re simply going to have to do a better job.
Steve: Yes, banks will need to be better, but many management teams have not been exposed to the added level of regulatory scrutiny that goes along with growth. For example, simple excel-based models most likely will need to be redesigned to incorporate more factors, assumptions and data, as the banks’ operations become larger and more complex. As banks grow, we suggest that they perform a readiness assessment, which includes a review of risk exposures and quantification, risk management framework, model risk management, governance practices, liquidity, and capital optimization, so that they can get a read on what may be ineffective for a bank of a larger size. From there, transition strategy and roadmap can be developed. Ankura’s team has worked with may banks to help them with this important step into maturity.
Q: Ankura has a large valuation business, how do you see CECL impacting valuations and M&As?
Dave: CECL will add another level of complexity to the valuation and M&A diligence.
CECL changes the way credit adjustments are treated as the ALLL is booked and expensed at acquisition. Fair value calculations on loans continue to adjust for non-credit issues, such as interest rate, liquidity, servicing and capital return requirements. So, the Day 1 impact of an acquisition will have a larger negative impact on the P&L, as the newly booked ALLL will reduce earnings, more than the current practice, of amortizing the credit discount over the life of the assets, although, the economics of the loan portfolio have not changed. The optics of this short-term timing event requires a concise communication effort to prepare investors, regulators and other stakeholders.
The bigger challenge will be in due diligence, especially on the CECL framework, portfolio similarities and differences, as well as the differences in geographic footprint of both the target and acquiring financial institutions. If, for example, a transaction is a market consolidation among two nearby banks with similar portfolios, the acquirer’s existing CECL model assumptions, data, and adjustments will likely work, assuming the portfolios and loan policies are similar. This is less true in acquisitions that are market extensions or out-of-market and diversification plays.
Steve: Also, differences in CECL modeling approaches pose yet another concern. A bank with a sophisticated, loan-by-loan model that acquires a target with a less complex box model, perhaps only using call codes may find the ALLL calculations and documental evidence is inadequate and inconsistent with the acquiring bank expectations and approaches. As such, model methodologies, assumptions, data, Q-factors, adjustments, and forecasting will likely be very different from market to market. Aligning the models to record a combined ALLL, with a consistent approach will add to the complications of integrating an acquired business. Acquirers should be prepared to conduct due diligence and validation of everything, from inputs to external environments, to how the model works, to ensure the target’s CECL model was properly validated and is up to the acquiring bank’s standards.