Much has been written about these regulations. Many thought that DFAST would be eliminated or at least rewritten, which now does not appear to be the case despite the deregulatory mood in Washington.
Prominent economists and the FOMC favor the protections that it affords and believe that it will shore up our financial system during future downturns. Effective 2016, the compliance deliverable is a public statement by larger banks that they are prepared for any shock to the system including one as large as the Great Recession.
CECL becomes effective in 2020 and 2021 (depending on how a Public Business Entity is categorized), and it will require banks to be forward-looking with regards to their loan portfolios. They are required to assess the future risk for each loan and accrue for projected losses. Its purpose is to assure shareholders that the bank has sufficient reserves should there be defaults. It will make banks counter-cyclical – expanding reserves when fundamentals are strong as opposed to when they are weak. Banks have been preparing for it for a while: they have been storing historical loan and transaction information.
The two regulation’s purposes are obviously different, but there is one similarity: they both involve banks’ proprietary data as well as outside data. There is a market aspect to the data that banks may or may not have such as economic and commercial real estate information. Banks must show quantitative proof of their assumptions, which involves a blend of their data and that of data vendors. Since DFAST compliance is already in existence, banks have or are already determining their data requirements. CECL, however, is new and banks are still trying to understand how to comply.
Here is the advice that the Federal Reserve Bank Board of Governors has given regarding CECL data:
"When developing estimates of expected credit losses on financial assets, the institution should consider available information relevant to assessing the collectability of cash flows. This information may include internal information, external information, or a combination of both relating to past events, current conditions, and reasonable and supportable forecasts."
They also said that fair value remains the standard, which means appraisal data must be considered:
"The agencies plan to retain their existing requirement that an institution must use the fair value of collateral for determining the allowance for credit losses for a collateral-dependent loan HFI (Held for Investment)."
Frequently Asked Questions on the New Accounting Standard on Financial Instruments – Credit Losses, Board of Governors of the Federal Reserve System, September 6, 2017.
FASB has also stated that banks will have added expenses with regards to data due to CECL:
"In addition, many organizations may need to consider changes to processes and controls to ensure that they are measuring credit losses in accordance with the new standard. Organizations may also need to gather and/or obtain incremental data relevant to the expected credit loss method that they believe is appropriate for their type of assets and sophistication level."
Understanding Costs and Benefits, ASU: Credit Losses (Topic 326), FASB, June 16, 2016
Compliance absorbs a lot of a bank’s resources. Each institution seems to have their own strategy for how to comply: some banks handle it entirely inhouse, while others outsource parts of the work or all of it. Whatever route they take, the data, methods, and models must pass muster with the regulators. Outside, reliable data is an important component, and it must be high-quality: if the underlying data are not accurate, the models and forecasts fail, and regulators then require that the bank remedy the errors, lengthening the process. Starting with proven data is a good first step.
*Image from Shutterstock.com
