With almost a year until some public business entities must begin complying with the current expected credit loss (CECL) standard, banks and credit unions have been fervently beginning transition practices, and their preparations have taken center stage in regulatory and financial news. However, a topic less prevalent amidst current CECL discussions is the fact that non-banks also need to comply.
Specifically, the standard states that it will “affect entities holding financial assets and net investment in leases that are not accounted for at fair value through net income.” This includes:
- Debt securities
- Trade receivables
- Net investments in leases
- Off-balance-sheet credit exposures
- Reinsurance receivables
- Any other financial assets not excluded from the scope that have the contractual right to receive cash
The non-bank financial institutions that need to adhere to the CECL standard range in purpose, size and complexity. For example, some of these non-bank entities include mortgage and equity Real Estate Investment Trusts (REIT), automobile financiers and private equity firms. Overall, the credit impairment standard will apply to any specialty finance company that engages in lending practices.
In an interview during Nareit’s REITwise annual conference, EY partner Serena Wolfe noted how the credit impairment standard will be a large modeling change for both mortgage and equity REITs. This includes an impact on trade/loan receivables and any debt investments that REITs might have.
“It is a huge change in the model whereby they don’t just have to look at historical losses now, they have to forecast out what an expected loss might be,” Wolfe said during the interview. That’s taking into consideration outside factors like potential economic downturns.
Learn more about navigating the CECL transition.
What the changes entail
According to a presentation by RSM, the most impactful changes for specialty financial companies include:
- Recognition of expected credit losses for the entire life of the loan, on day one
- A transition from an incurred loss to an expected credit loss model
- Adjustment of historical loss experience for current conditions and reasonable and supportable forecasts
- Adoption of special rules for purchased loans with credit deterioration
- Recognition of all subsequent changes in the allowance for credit losses in earnings through increases or decreases in the credit loss expense
In order to recognize expected losses, the presentation highlighted that non-banks can use a static pool/vintage analysis to make CECL calculations. This is a well-documented calculation and is a good way to understand a key lifetime loss concept. However, it may not be applicable to all loan types; for example, its use for revolving lines of credit is limited due to their frequent renewal or extension. Data requirements can be challenging when conducting a vintage analysis. Often, the length of loan history through accurate origination and renewal dates can make this calculation more complex. Although this may bring some challenges, a vintage analysis is still a good way of calculating the ALLL. Vintage analysis is best for pools that are homogeneous in risk and term, with high loan counts.
For specialty financial companies that have little to no historical data, they can use a discounted cash flow (DCF) method. The DCF method represents cash flows in the future on a per loan (bottom-up) basis. It uses periodic, time-bound parameters in estimation. This methodology can be applied with relatively few loan-level details (as little as one year) and layering of peer experience is common, as are applications of reasonable and supportable forecasts due to the time-sensitive nature of this methodology.
In addition to using new methods for CECL calculations, the way purchased credit deteriorated assets are treated is a significant change to current GAAP practices. Adoption of the credit impairment standard will have a large operational and financial statement impact on non-banks with acquired loan portfolios. A solid understanding of the accounting changes will result in an improvement to current treatment, transition planning, vendor/model selection and go-forward day one decisioning.
Overall, it is important that non-banks start making preparations for the credit impairment standard since most are among the first entities who have to transition in Q1 2020. “I don’t think that you will find that there will be a significant dollar value impact or significant change in the way that they record, but it’s going to be a significant process change. It will require them to do modeling and think out, economic forecast wise, things that they have never done before,” said Wolfe.
Whitepaper: CECL Practical Transition Guide
Webinar: Interpreting CECL Modeling Results