Mike:               Hi, my name is Mike Gullette, Vice President of Accounting and Financial Management for the ABA, and this is a very brief introduction to FASB's current expected credit loss accounting standard, also known as CECL. The standard will be effective in 2020 for SEC registrants and 2021 for all others with an early adoption allowed. My bet is that you have concerns about CECL, and we do too. ABA recommended to FASB an impairment accounting model that largely reflects how you evaluate loan impairment today. Instead, FASB opted to require that both current and future losses in a portfolio be recorded. This will require an overhaul of many processes throughout your company. You will incur additional costs not only in setting up a CECL process, but also to make it run thereafter.

Mike:               Now, a word of caution. CECL represents the biggest change to bank accounting ever. If you're a CEO and you just tell your CFO to take care of this, you'll spend a lot of money on this and fail. Your capital will swing back and forth and each quarter's results will be a big guessing game. This will negatively impact your ability to serve your customers and communities, so don't just think of CECL as an accounting change, but rather a change to how all banks manage their business. Now, current accounting principles have been in place for about 40 years and is referred to as incurred loss accounting, meaning something probably happened that caused impairment to the loan for practical purposes. That impairment is normally measured in pools of loans and is heavily based on historic annualized charge-off rates. In contrast, CECL is an expected loss notion. An event does not have to have occurred but can be expected in the future. Further, that historical data that CECL relies upon is not annual loss rates but is on life of loan or life of portfolio loss rates.

Mike:               This is a big difference that can be easily misunderstood, and we'll look at that in just a minute. Conceptually, I like to think of current accounting as recording the losses in your portfolio and CECL recording the risk in your portfolio. So let's look at what the CECL standard says. Keep in mind, ABA has a wealth of information about CECL including a CECL background document that will give you much more detail about the good, the bad, and the ugly of the new standard, all available on aba.com, but CECL is actually relatively simple. First, a life of loan loss expectation is effectively recorded at origination. For practical, just like we do today, this will be done for pools of loans.

Mike:               Now, this requires a forecast of the future which includes a forecast of economic indicators such as interest rates and unemployment. Now, historic averages of life of loan losses are very important in CECL. First, like today, they are used as starting points for estimates of expected loss. Second, many bankers both big and small, expressed concern about their ability to forecast into the future past a couple of years. Under CECL, you will forecast as far into the future as you can, and that's what I call the forecastable future, then use unadjusted historic averages of losses past that point.

Mike:               Now, don't expect a lot of detailed rules in the standard of how to do it. FASB writes high level principles with no prescribed measurement methods. Even the implementation examples I've seen leave out a lot of the detail needed to satisfy the intent of CECL, and the devil is in the details. Now, the key to understanding CECL is understanding the life of loan loss concept. Today, we usually think of annual loss rates, but if you think you'll just take an annual loss rate and multiply it by the expected life of the portfolio, you will be wrong. That is because losses don't occur evenly throughout the life of a portfolio.

Mike:               Here we have a picture of a loss curve, which shows this fact for a specific vintage or group of loans originated in the same year. Charge-offs on these loans, which show a pattern similar to many residential mortgages, increase the first two years and then peak and then taper off significantly after that. Simply speaking, the area in the orange curve represents the total amount of risk this group presents over its life, with the charge-offs on the left being the risk that has been actualized and the allowance on the right being the risk that remains. If most loans are two years old, we expect significant additional charge-offs, those in the greenish area. Now, if our loans are three years old, however, we have much less risk in front of us. The allowance would then be a lot smaller. Now, that's not a terribly complicated concept, but remember, an average portfolio normally has many vintages outstanding, and a forecast of the future then compounds the complexity as different loan terms and maturities react differently to the economic assumptions that are forecast.

Mike:               At a very minimum, a CECL estimate will require more granular information and a more detailed analysis. Let's talk about the biggest challenges you will face as a CEO. First, you'll need to communicate with your investors and management early and often about CECL. Like I just showed, terms like loss rates will have new meaning. You need to make sure everyone is singing off the same song sheet. The relationship of traditional credit metrics no longer continues. Today, delinquencies or non-accrual loans go up and so does the provision. No longer is that the case, as those provisions are supposed to be recorded at origination. Therefore, new metrics will be needed, and they will be needed to be communicated over and over. Remember, we need to unlearn 40 years of knowledge here.

Mike:               Number two, the auditors. I've talked about the need for life of loan data. The vast majority of the data needed to support a life of loan loss estimate is probably not collected by your bank currently, so there will be costs in accumulating past data and collecting and analyzing it on an ongoing basis. Remember that CECL's life of loan loss notion is also a much bigger playing field than we have today. Small changes in your assumptions will make very large changes to your loss estimates. When changes to those loss estimates mean the difference between a dividend or not, support for how you quantified those assumptions also will be important. Much more detailed analysis is required based on much more granular data. Now, of course, less sophisticated banks will not be expected to have sophisticated analysis, but you will need the data and you will need to address the unique issues in some way. Finally, you have to address your regulators. They will want you to align your CECL assumptions to your budgeting and planning. The expected increases in interest rates that are driving your pricing should be integrated into your CECL estimates and those results then get fed into your capital plans.

Mike:               Remember how I said that CECL is about reflecting the risk in your portfolio? This is why I believe CECL could change how you manage your bank. Now, CECL is effective in 2020 for years SCC registrants in 2021 for everyone else with early adoption available. Now, that gives us a decent amount of time before we need to do anything right? Wrong. Remember I just said that most banks do not currently collect the data needed to perform a life of loan analysis. At a minimum, we need to start collecting data as soon as possible. However, as you see on the chart, there are a lot of things to do when implementing CECL, and I'm not going to discuss those steps. I will talk about what you should do now.

Mike:               Before you make any decisions on implementation, the most important thing to do now is to take a step back and make sure to get educated. Education should be a priority before any decisions are made related to implementation. I've talked about the CECL backgrounder paper we have on aba.com. Reviewing the regulatory guidance will help, but they're not recommending any specific methods or practices at this point. Also, expect auditors and software firms to come out with their presentations, and those should be fine, though I expect them to be told from their point of view. What you will need may be different.

Mike:               With that in mind, ABA will be offering two webinars. First, Five Questions You Need to Answer Before Making a Decision on CECL to be held in July, and the second is on CECL Measurement Methods: Advantages and Disadvantages, which will be held in August. We'll also be offering a special CECL implementation workshop at the ABA CFO exchange conference on September 19th to 21st in Charleston, South Carolina. ABA also has discussion papers that address CECL, and I urge you to have your relevant staff sign up for our newsletters and peer groups. The peer groups will allow members to share their experiences and learn from others. If you have any other questions, you can call me at 1-800-BANKERS or send me an email. Thank you for your attention.