Expected Loss Moves from Risk Management to Accounting Standards

05/22/2013

 by Suzanne Storm & Louis J. Dunham

The Financial Accounting Standards Board has proposed a fundamental change in the way the allowance for credit losses is calculated and presented.  Comments on the proposal are due to FASB by May 31, 2013. FASB intends to review comments on an upcoming proposal by the International Financial Reporting Standards, so it is not clear how soon an accounting change will take place.  

However, given the proposed requirements, Ardmore believes that its client banks should not only be aware of the change, they should also begin planning any systems or process changes that may be necessary in order to comply.

Background and Proposed Change
There were two weaknesses exposed in existing accounting standards in the financial crisis that began in 2008: 
  1. Loans and other financial assets were overstated due to delayed recognition of credit losses
  2. Multiple credit impairment models led to inherent complexity in financial statements of banks and other financial institutions
The proposed accounting change is intended to address both of these weaknesses by replacing the current impairment model, which requires that a credit loss be “probable” before being recognized, with a requirement that “expected” credit losses be reported in each periodic financial statement.  This is significant since even Pass credits may carry some amount of expected loss (depending on the risk rating) and therefore the new requirement will substantially broaden the pool of credits reflected in the Allowance.

The proposed changes will require:
  • The balance sheet to reflect the current estimate of cash flows expected to be collected from all loans and other financial instruments (carrying value minus expected loss – a current estimate of all contractual cash flows not expected to be collected) and 
  • The income statement would reflect credit deterioration or improvement that has taken place during the period (the change in total expected loss).  
Arguably, the new proposed method would provide a more accurate assessment of expected losses to a reader of a bank’s financial statement although it may also add further volatility to the statements as well.  

Expected Loss 

In order to report an accurate estimate of expected loss, a bank will be expected to take into account, and have data supporting three primary issues, including:
  • Quantitative and qualitative factors specific to the borrower, including a current evaluation of the borrower’s creditworthiness.  Factors may include indicators such as:
    • Consumer credit risk scores 
    • Credit rating agency ratings 
    • An entity’s internal credit risk grades 
    • Loan-to-value ratios 
    • Collateral 
    • Collection experience 
    • Other internal metrics 
  • The general economic conditions and 
  • The current point in and the forecasted direction of the economic cycle
The allowance for expected credit losses must include not only loans outstanding, but also unfunded commitments.  In order to estimate these, both the likelihood that funding will occur (which may be affected by contingencies such as a material adverse change clause) and expected credit losses on the amounts funded must be estimated.

The estimate of expected credit losses must reflect the time value of money either explicitly (via discounted cash flow) or implicitly (by use of such methods as loss-rate methods, roll-rate methods, probability-of-default methods, or a provision matrix method using loss factors).  
  • If discounted cash flow is used, the discount rate must be the effective interest rate of the financial instrument being valued (unless it is a lease).   
  • For collateral-dependent financial assets (which typically includes, from the regulators’ standpoint, all loans rated Substandard or worse), the fair value of the collateral (adjusted for selling costs) may be used to measure expected credit losses.  
How to Estimate Expected Loss

The historical average of credit losses that would be expected for financial assets with similar risk characteristics must be established.  The source of this data is typically the bank’s own experience.    In order to meet the new standard the bank will need to demonstrate historical performance by loan vintage, risk rating, or other categorization of “assets with similar risk characteristics”.

In addition, because the historical average may not adequately reflect current conditions, a credit risk adjustment may be necessary to ensure that the expected credit loss estimate reflects current conditions, including the state of the economy, borrower behavior, collateral values, how current underwriting standards compare with those in the historical data, etc.  These factors may become more evident as an economic cycle unfolds.   The process of developing the credit risk adjustment is analogous to the current qualitative factors used to develop the ALLL.  

An excellent example of the importance of taking such factors into account is the recent experience with residential mortgages.  Because of the home value bubble, loosening underwriting standards, and changed borrower behaviors, actual mortgage loss rates far exceeded historical averages to differing extents across the country.  

Under the proposed accounting change, a bank would have been expected to take each of these factors into account as they emerged, modifying expected loss estimates relative to the historical average, and applying the observed changes in borrower behavior to its portfolio of underwater mortgages. 

Banks need to consider the effects of these proposed changes as soon as possible to assure their provision and allowance is adequate. We are not sure when the proposal will be adopted, but we do not want you to be caught unprepared. If we can be of assistance, please call 610-649-4643, or email Suzanne Storm at sstorm@ardmoreadvisors.com, Joe Rebl at jrebl@ardmoreadvisors.com or Lou Dunham at ldunham@ardmoreadvisors.com.