Accounting

5 Ways to Prepare for CECL: A Q&A With SS&C’s John Lankenau

There is a vast disconnect between the way banks feel about the new current expected credit loss (CECL) standard and what they’re actually doing to prepare.

According to a survey on CECL readiness by SS&C, 85 percent of respondents, which included accounting professionals within financial institutions, expressed being confident or somewhat confident in the ability of their existing reserving process to address the CECL transition. However, 47 percent of respondents cited managing a massive amount of data as their top concern. FEI Daily spoke with Head of Product Solutions & Operations at SS&C Primatics, John Lankenau, about the survey results and the steps finance teams must take to prepare for the changes.

FEI Daily: How did the current expected credit loss (CECL) standard come about and who does it impact?

John Lankenau: Reserving is an interesting one, because it requires cooperation across risk and finance. Typically there is somebody in the risk organization who will run the allowance model and will actually generate the allowance estimate. But the overall umbrella is under the finance organization or the controller, because that estimate has to be presented on the financial statements to investors, and the regulatory reporting folks are going to be interested in it too, because the regulators are very interested in reserves.

The existing standards for reserving are written in a way that don’t let banks or other financial institutions take a bigger reserve early enough in the cycle to make a difference. The banks might have thought they’d be losing more money later on, but they couldn’t reflect that in the financial statements, because of the way the financial standard was written. It uses something called an ‘incurred loss’ which is really kind of an unusual concept. It basically says you don’t get to hold a reserve against something, until you think that the loss is already probable. So, it means you already have a pretty good idea that it’s going to happen.

The CECL standard now says the reserve for a loan is actually equal to what you think you’re going to lose for the whole contractual life of the loan. Now you say for every loan that you hold on your balance sheet you actually hold a reserve against that for the entire contractual life loan. That’s a big conceptual change.

FEI Daily: What was the disconnect that the survey uncovered among the banking sector’s readiness for CECL?

Lankenau: The one that surprised me was 85% of the respondents are confident in their existing reserving process to address the CECL transition. That number felt a little high, especially when looking at some of the biggest obstacles they said they’ll face. Almost half said the biggest obstacle was going to be managing an overwhelming amount of data. It feels like we’ve spent a lot of time trying to figure out why is it that folks are so confident, when they’ve identified some of these big challenges that they’re going to face. Time will tell, as we talk to more people in-depth. I suspect it’s just the natural tendency to do a little bit of underestimation of the difficulty of a big project before you enter into it. So it’s something that we’re still looking into trying to understand more deeply.

FEI Daily: How are accounting professionals handing their reserving processes today?

Lankenau: It depends a little bit. Larger ones are going to tend to have more sophisticated types of technology, more sophisticated tools, better ability to do reporting. But they also have more complex institutions in general, so even though they have more powerful tools, they don’t always necessarily get to a better answer, because their business itself is more complex.

Smaller institutions have simpler needs, generally, and use simpler tools. But, in general, you have people who do things in spreadsheet. There are some vendors out there who make software for reserving, and those range in sophistication, we’re on the higher end of the sophistication range for the reserving vendors. And then some banks have also built custom-made software programs themselves. They’ll write something in Java or maybe in SAS, something like that.

FEI Daily: The effective date for transition to CECL is 2020 for SEC-registrants and 2021 for others. Have companies started preparing for implementation?

Lankenau: Yes. Most institutions of a decent size are going to be SEC registrants. As you get to smaller banks, you might see some who aren’t. It says, “For fiscal years beginning after January 1, 2020”. I think the first time most people have to do it is first quarter of 2020. But that said, most of the time when we do an implementation for banks or something that’s a relatively large change or an important process, they inevitably want to run the new process in parallel for some period of time in a pseudo-production environment, before they actually push the button and say, “This is the real thing that we’re going to go out with.” You want to make sure you get all the kinks out first.

FEI Daily: How should institutions prepare for the operational impacts of CECL adoption now?

Lankenau: There are five things that people need to think about right now. The first one is just a basic gap analysis. The accounting standard is not very prescriptive. Most institutions are going to have to go through their balance sheet and go through the assets they have, and ask themselves the question, “Is this a CECL asset?” Yes or no. If it is a CECL asset, “What am I going to do?”, “What kind of accounting policy do I need?” “What kind of loss estimate do I need for the view to get a life of instrument loss?”. And then say, “Do I have a model that does this?” And if you do have a model, then you ask the question, “Is this model good enough for CECL or do I need a different model?” And if you don’t have a model, then you have a gap to fill.

The second thing I think people need to think about as that this isn’t just a project, it’s a project that ends in a process, and that’s really important. You have to remember that whatever you wind up doing, you’re going to have to do it for the indefinite future.

Third is how to generate loss estimates. With the probably exception of the very largest institutions, generating life of instrument loss estimates will be new. Organizations must understand how they are going to achieve this. Will they invest in real econometric models, or will they have more of an analytical process? Will they build or purchase models, or use a combination of both? How can they generate the estimates in a controlled, efficient way that supports the required analysis? These are all questions that must be addressed to help ensure a smooth transition.

Fourth, you want to think about what kind of data you’re going to need to satisfy this new process. For lots of institutions, there will be changes to their loss estimation methodologies. For smaller banks in particular, they’re going to have to do forward-looking estimates for the first time, and that’s not just going to be an operational change, it’s going to be a big mindset change.

Finally, there’s analytics and disclosures. This new standard is designed to be sensitive. If the world starts going downhill, they really want institutions to start taking a bigger reserve – and the way their reserve works is that every time you take a dollar in reserve, you actually lose that dollar in the period you take. It changes income in a material way. There’s going to be many stakeholders who are really interested in, “why did my net income go down last period?”. Is it because they actually have bad loans on the portfolio, or their view of the future changed?  There’s going to be an abundance of analytics that must be analyzed to ensure that regulators, auditors, the board, senior management and investors are all comfortable with what’s going on.

FEI Daily: You mentioned an overwhelming amount of data as a challenge. What are the other obstacles that companies are going to face?

Lankenau: Historically risk and finance haven’t been the most integrated of groups and there’s been a lot of talk recently about making them more integrated. The risk team, especially ones who do real models that are forward-looking, tends not to exist inside production processes, so there will have to be a productionalizing of real forward-looking views so that it actually meets the control requirements of finance. And that’s not trivial at all.

Large institutions that have real models tend not to have them in the kinds of processes that are Sarbanes-Oxley type compliant. The smaller institutions don’t even have the right kind of models to allow them to be able to look forward in any kind of robust way.

FEI Daily: How are companies planning to complete the accounting cycle close while transitioning to CECL?

Lankenau: Basically 50% of the institutions are just going to ask their folks to work a little harder, and roughly a quarter said there will be a dedicated CECL transition team. It’s likely going to depend on the size of the bank. I think the smaller institutions tend to ask their teams to wear many hats, and so they’re going to put a bigger burden on some of them to both keep the lights on and also run the transition, where larger institutions tend to have more ability to have project teams that are separate from the people who are actually doing the production processes. It’s definitely going to be a lot of work for institutions.