Finalized Regulatory Guidance on CECL Implementation and Credit Risk Review Systems
By Gina Omolon and Jonathan Sinaw
The financial regulatory agencies announced that they had finalized their jointly issued Policy Statement on Allowance for Credit Losses (“ACL Policy Statement”).
The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation and the National Credit Union Administration (together, the “Agencies”) released, on May 8, 2020, the ACL Policy Statement to promote consistency in the interpretation and application of the Financial Accounting Standards Board’s (“FASB”) Current Expected Credit Loss (“CECL”) standard. On the same day, the Agencies also announced their finalization of separate Guidance on Credit Risk Review Systems (“Guidance”) which they proclaimed, “discusses sound management of credit risk, a system of independent, ongoing credit review, and appropriate communication regarding the performance of the institution’s loan portfolio to its management and board of directors.”
Policy Statement on Allowance for Credit Losses (“ACL”)
The ACL Policy Statement becomes effective for financial institutions upon their adoption of CECL, which is January 2020 for calendar year-end public business entities that are also SEC filers, excluding smaller reporting companies as defined by the SEC, and January 2023 for all other calendar year-end public business entities and private companies.
The ACL Policy Statement outlines appropriate “design, documentation, and validation of expected credit loss estimation processes, including the internal controls over these processes; the maintenance of appropriate ACLs; the responsibilities of boards of directors and management; and examiner reviews of ACLs.” It does not, however, specifically state requirements for estimating expected credit losses. The newly finalized ACL Policy Statement replaces the December 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses and several other policy statements, which will be rescinded when all institutions have adopted CECL.
The CECL methodology applies to financial assets measured at amortized cost, net investments in leases, and off-balance-sheet credit exposures and replaces the current “incurred loss” methodology, which is predominantly historically-focused, to a new measure that is forward-looking. The new standard asks lenders to create ACLs on their loan portfolios, including off-balance sheet exposures, by estimating losses over the life of the loans. CECL also includes securities that are classified as held-to-maturity and modifies the accounting for impairment on debt securities classified as available-for-sale. Due to the variability in financial institutions’ size, complexity and risk profiles, the FASB realized that a one-size-fits-all approach would not be appropriate for CECL and opted to provide financial institutions with a high degree of flexibility for implementation.
Key Takeaways from the ACL Interagency Policy Statement
The ACL Policy Statement states that each institution should create a comprehensive, well-documented and consistently applied methodology through their policies and procedures with consideration of all significant factors affecting credit risk and collectability of the financial asset portfolios. Considerations include:
- The roles, responsibilities and segregation of duties of senior management and other individuals from various, relevant departments
- The processes for determining financial assets segmentation, approaches for determining historical period(s) and adjusting historical credit loss information, processes for incorporating reasonable and supportable forecasts, determining and revising appropriate reversion techniques and reversion periods
- The processes for data capture and reporting systems used to ensure the integrity of the data used in the ACL’s calculation, whether obtained internally or externally.
- The determination of CECL allowed accounting policy elections and practical expedients that should be made by management and documented, including, but not limited to, policies for the prompt write-off of financial assets, and the treatment of accrued interest receivables.
- Procedures for the independent analysis and validation of the measurements and assumptions used and the systems of internal controls used to confirm that the ACL processes are maintained and periodically adjusted to ensure the relevance, reliability and integrity of data.
Analysis and Validation of ACL Measurement
An internal review and challenge process should be in place to evaluate management’s assessment of, and justifications for, the reported amounts of ACLs. This can be done by members of the board of directors or a committee thereof. The ACL Policy Statement notes that ratio analysis, peer comparisons and actual vs. estimate analytics can be useful tools for analyzing ACLs, but should not be solely relied upon in place of a comprehensive analysis of the related financial assets and factors affecting their collectability. The ACL Policy Statement added that neither the board of directors nor management should further adjust ACLs beyond what has been appropriately measured and documented in accordance with FASB ASC Topic 326.
After analyzing ACLs, management should also put in place a validation process to confirm that the process remains appropriate for the institution’s size, complexity and risk profile. Those performing the validation should have appropriate knowledge, technical expertise and independence from the institution’s ACL estimation and credit approval processes, but do not necessarily need to be hired from outside the organization.
Responsibilities of the Board of Directors and Management
The ACL Policy Statement puts ultimate responsibility for the institution’s ACL in the hands of the board of directors or a committee thereof and specifies that board oversight will be subject to review by examiners. Responsibilities of the board include selecting qualified management to oversee the ACL, reviewing related policies and procedures at least annually, reviewing management’s assessments of the ACL, approving internal and external audit plans regarding the ACL as well as reviewing any audit findings and their subsequent remediation.
Management, on the other hand, is responsible for determining and maintaining the ACL in accordance with GAAP, regulatory requirements and internal policies and procedures. Management is also responsible for appropriately documenting the ACL measurement and all judgements, forecasts, and internal and external factors involved.
Guidance on Credit Risk Review Systems
The Guidance on Credit Risk Review Systems is effective for all institutions supervised by the Agencies upon its pending publication in the federal register and will replace “Attachment 1” of the aforementioned December 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses as its own standalone document.
The Guidance discusses the objectives of an effective Credit Risk Review System regardless of the structure within an organization, which include the following:
- Timely identification of loans with actual and potential credit weaknesses;
- Validation or adjustment of risk ratings, especially for those with potential or well-defined credit weaknesses that may jeopardize repayment;
- Recognition of relevant trends that impact portfolio quality;
- Assessment of the adequacy of internal policies and compliance with those policies in addition to laws and regulations;
- Evaluation of activities of lending personnel and management including the quality of their loan approval, monitoring and risk assessment; and
- Supplying management and the board of directors with an objective, timely and independent assessment of the overall quality of the loan portfolio for strategic decision making as well as for financial and regulatory reporting purposes.
To complete the above objectives, each institution should develop a credit risk grading framework that provides important information on the collectability of each portfolio. An independent risk rating review process will provide a more objective assessment of credit quality, however, smaller institutions with fewer resources may adopt modified review procedures to achieve some degree of independence.
While the findings of an institution’s credit risk review system can provide insight on the reasonableness of the ACL, the Guidance stresses that this function should be treated separately from the calculation of the institution’s allowance. Listed in the Guidance are the following elements of an effective credit risk review system:
Personnel Qualifications – Personnel performing the Credit Risk Review function should be qualified and knowledgeable based on their education, experience and training.
Personnel Independence – Personnel performing the Credit Risk Review function should be independent of the credit approval process, though it is not necessary for them to be from outside the institution. Such personnel should report directly to the board of directors or a committee thereof.
Frequency of Reviews – The Guidance recommends that significant loans or groups of loans should be reviewed annually, though more frequent review may be necessary if deteriorating credit quality is indicated or if other risk factors are present.
Scope of Reviews – The review should cover all segments of the loan portfolio that pose a significant credit or concentration risk with the remaining loans based on an institution’s own established criteria developed with the institution’s size, complexity, loan types and risk profile in mind.
Depth of Portfolio Reviews – The review should cover the areas of a loan or segments of loans that are evaluated during the review. Examples listed in the Guidance include creditworthiness of guarantors, sufficiency of credit or collateral documentation, adherence to loan covenants and the accuracy of the risk rating given.
Review of Findings and Follow-Up – Processes, reporting lines and monitoring should be in place for all noted review findings including any deficiencies and weaknesses. Any disputes over credit quality should usually be decided by the lower rating unless new information can be provided to obtain agreement for the higher rating.
Communication of Results – Results of the credit review process should typically be communicated to the board of directors quarterly, though more frequent communication may be necessary when material adverse trends are noted.
Both, the ACL Policy Statement and the Credit Risk Review Guidance are helpful tools for financial institutions to use in their implementation of CECL and in strengthening their current Credit Risk Review Systems while aligning with regulators’ requirements. Full versions of both, including agency thoughts and updates based on stakeholder comments, can be found at the following links: