Financial Instrument Credit Losses FASB Exposure Draft

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Financial Instrument Credit Losses
FASB Exposure Draft (Subtopic 825‐15)

1 Texas  Michigan  Florida Insight. Oversight. Foresight. SM

FASB – Why Address the Topic? Financial Institutions Group

• In 2009, FASB pursued a project to address
impairment, classification, and measurement of
financial instruments.
• Loan impairment changes proposed respond to
financial crisis criticism: “too little, too late.”
• Various assertions surfaced commenting (assumed
to be from investors and regulators) banks were
inadequately reserved prior to the crisis, due to
inherent constraints of the “incurred loss”
impairment model used.

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Financial Instruments ED Scope Financial Institutions Group

• The ED redefines how financial institutions will
measure allowance for loan losses (ALLL) and
other than temporary impairment (OTTI) on debt
securities.

• Impairment for both loans and securities will use
the same model.

• Today we will focus our discussion on the Loan
Portfolio implications.

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Are trading securities and loans Financial Institutions Group
held for sale included? Master
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• Loans held for sale and trading debt securities will
not use this impairment model.

• Changes in fair value will be recorded straight to
net income.

• This exposure draft will specifically address loans
held for investment, held-to-maturity debt
securities, and available for sale debt securities.

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Loss Models – Incurred Loss Financial Institutions Group

• Current GAAP for the ALLL is based on an “incurred loss”
basis – the ALLL represents what you think you will lose on
events “that have already occurred.”

• A portfolio of good (performing) loans, historical data shows
what probably happened that will result in losses.

• Although the specific loans have not yet been identified,
(previously termed FAS 5), an amount is typically estimated
based on historical data for pools of loans.

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Loss Models – Incurred Loss Financial Institutions Group

• Bank controllers and examiners often refer to
“emergence periods”, which means the allowance
at a specific date represents the losses likely to
emerge over the next X quarters.

• ALLL often represents 12 months’ rolling charge-
offs; however, it could be more or less depending
upon the types of portfolios.

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Key Loss Concept Changes within Financial Institutions Group
the ED
• Introduction of the Current Expected Credit Loss
(CECL) model for impairment. An allowance for
credit losses represents “an estimate of all
contractual cash flows not expected to be collected
from a recognized financial asset (or group of
financial assets) or commitment to extend credit.”

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Model – Current Expected Credit Loss Financial Institutions Group

• CECL model: ALLL for performing loans will include
losses for events that have occurred and may be
expected over the life of the loan (LOL).

• Forward-looking factors must be considered in
estimating the ALLL, including how you think the
economic cycle will progress and how your portfolio
will perform over long time periods.

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Key Point: Definition of Expected Financial Institutions Group

• How you interpret “expected”?
• Will change the frequency and type of data and
documentation required to support the estimate.

• Could significantly change the amount of ALLL
that is ultimately recorded.

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“Life of Loan” = “Expected” Financial Institutions Group

• “ABA believes most banks do not currently have sufficient “life of
loan” (LOL) loss data to support ALLL estimates needed.”
• Type of documentation required may present a challenge for the
community banking sector. Types of market data and reliability
would be critical to consistency and linkage to factors influencing
loan degradation over its maturity.
• On a practical basis, market data from Moody’s or other rating
agencies works for extremely large credits and money center
bank loans.
• Community banks must acquire local relevant data and
adjustment this data to align with their specific underwriting terms,
geographic location, etc.
Source: American Bankers Association (ABA)

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“Life of Loan” = “Expected” Financial Institutions Group

Community Banks Challenge and New Skills

• Finding, supporting and adjusting market data for adjustments
may prove quite challenging.

• Frequent changes to any assumed loss rates, because the apply
to many forward looking (periods) years, could add significant
volatility to the ALLL.

Association (ABA)

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Expected ALLL Model Financial Institutions Group

• “The most visible criticism of the current incurred loss model is
that banks knew there was much higher risk in their subprime
portfolios, but were unable to provide for it, due to the fact that the
losses had not yet been incurred.

• CECL is proposed mainly to capture such risks, without insisting
on a true LOL loss, the new model would be operationally simpler
as well as making the ALLL balance easier to understand and to
explain to investors and management.”

• What about Community Banks and the commercial loan products
you provide your customer?

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Expected Financial Institutions Group

• Two important factors in whether the final CECL will
require a LOL loss allowance or not are likely to be
interpretations of the banking regulators and
preferences of the investment community.

• “ABA believes that the regulators support a LOL
loss concept, though they have not yet been clear
on how such a model will be implemented in any
level of detail.”


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ALLL Processes Financial Institutions Group

• This depends on the credit quality and type of loan:
• For individually impaired loans: those currently accounted
for under what was termed FAS 114; there likely will be
little change.
• For “purchased credit impaired loans”: these will be
accounted for similarly to impaired (“bad”) loans, as
opposed to the previous guidance outlined in SOP 03-3.
• For performing (“good”) loans: those currently accounted
for under what has been coined “FAS 5”, anticipate
significant methodology and value changes.

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• “FASB in 2011” has information that “the vast
majority of losses on loans occurs in the first two to
three years after origination of the loan, depending
on the type of product.
• Implying that current accounting standards, the
ALLL for healthy loans typically includes more than
one year of losses, and a new accounting standard
that is based on “next year’s charge-offs” for
healthy loans would not be adequate – neither in
size nor in methodology.”

15

• Vintage data may become a primary factor in the
ALLL analysis for consumer loans.

• Vintage data is typically able to capture when a vast
majority of losses occur.
• For example, 80% of your losses occur in the first three
years after origination of a specific product.
• Calculating the age of the portfolio can help provide
input in the estimation process.

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• Loss factors applied to migration data, delinquency
analyses, and credit ratings will have to be
recalibrated to charge-offs that come many years in
the future – not just within one or two years.
• The impact of underwriting terms on expected
losses will need evaluation, as banks may need to
use market data and adjust market data to reflect
their respective portfolios.

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What Can We Expect For ALLL Financial Institutions Group

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Impact title style
Utilizing an Expected Loss Model
• Losses would be recognized sooner than under the incurred loss
model – a financial institution would not wait for a loss event to
occur.
• In theory, expected loss ALLL balances will normally be higher
during normal and growing economic times.
• We believe ALLL balances will be higher under the CECL than
they are now. ALLL balances are currently lower in the banking
industry than they were during 2009 and 2010.
• Impact will be influenced by how regulators and auditors interpret
the CECL model.

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Impact Expected for ALLL Financial Institutions Group

• Big impact of the change will occur at transition –
banks theoretically will have a larger ALLL.
• Growing loan portfolios will record higher loan loss
provision expenses quicker than today.
• Banks with static loan portfolio balances may see
little change in their loan loss provision expenses.
• What is the impact to Basel III capital requirements;
• A key consideration of large banks.

19

Increased ALLL under CECL and current
Financial Institutions Group
capital requirement implications
• Capital requirements are considered to protect against
unexpected losses.

• ALLL should provide for expected losses. Consider current
coverage ratios and the increase that may result from LOL
• Implications of the CECL have not yet been considered in
conjunction with capital required under a final Basel III
regulatory scheme.

• Consider the range of estimates to determine the specific
impact of an expected loss model on current bank capital.

20

Bank Capital and ALLL Implications Financial Institutions Group
– Large, Medium and Small
• International Accounting Standards Board (IASB) members have
commented that CECL models could discourage lending, believing that a
large amount of ALLL will required upon loan origination
• Specific increases in a bank’s ALLL has not been quantified as this point.
• How will this potentially significant change impact lending or economic
growth? Of course, regulatory capital rules, which (as of January 2013)
are not finalized in the U.S.
• This is a critical strategic issue for community banks and their boards of
directors.
• Capital
• Stock valuation implications
• Earnings implications with higher ALLL and Capital
• Impact on net income and loan pricing

21

Will the CECL Model improve impairment
accounting and financial reporting?
• Life of Loan (LOL) timelines loss model provides information
that may not necessarily be more useful to creditors,
regulators, and customers.
• LOL expected losses; how will this method retain effective sensitivity
to current economic activity when compared to the incurred loss model
estimates?
• Accounting change can wreak havoc on analysts for creditors and
peers that rely on historical data for analysis.
• CECL model that applies LOL losses to healthy loans would be
expected to result in an abrupt change to historical data, making
annual comparisons very difficult.

22

CECL ‐ Will This Accounting Standard
Change Improve Impairment Accounting?
• Accounting methods that reduce the reliability of
reported loan losses (and usefulness of bank
earnings reports) will ultimately increase the cost of
capital.

• Cost of capital is significantly influenced by
regulatory capital requirements, it is also important
for industry, analysts, and the regulatory community
to work together to help the FASB refine its model.

23

Increased ALLL under CECL and current
capital requirement implications
• Capital requirements are considered to protect against
unexpected losses.
• ALLL should provide for expected losses. Consider
current coverage ratios and the increase that may
result from LOL
• Implications of the CECL have not yet been considered
in conjunction with capital required under a final Basel
III regulatory scheme.
• Consider the range of estimates to determine the
specific impact of an expected loss model on current
bank capital.

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Number of Failed Banks Financial Institutions Group


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Number of Failed Banks Financial Institutions Group


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Service Organization Control (“SOC”) Reports

27

SOC 1, 2, and 3 Financial Institutions Group

• SOC 1 Report
• Used during the financial audit of the
vendor’s customer to evaluate vendor
controls that might affect the financial
statement of the customer. (SAS 70)

28


• SOC 2 Report
• Used when customers need
information and assurance about
security, availability, processing
integrity, confidentiality or privacy.
Role in vendor management,
regulatory compliance and risk
management.

29


• SOC 3 Report
• Discusses security, availability,
processing integrity, confidentiality, or
privacy but does not include details
about the controls.

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Vendor Governance Financial Institutions Group

• Internal controls - vendors without industry
standard internal controls
• Vendors are not aware of the need in the financial
institution marketplace
• Small vendors that have not been required to gain
independent attestation of the controls or their
effectiveness
• Privately or closely held vendors that emphasize
efficiency over control
• For example, a small number of programmers are used and
can modify and implement anything into the software code

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Vendor Governance Financial Institutions Group

• Software that doesn’t meet industry standards or
financial institution policy regarding security
controls
• Unable to require complex passwords
• Unable to segregate duties with user access
• Weak programming controls resulting in either software
errors or weaknesses in security

32

What You Should Know Financial Institutions Group

• Read the report in its entirety
• You should understand how their
control system works from the
information provided
• Read the vendor’s system
description
• Follows a letter from the accountants
and a letter from management
• Should describe what the company
does to provide for internal control

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What You Should Know Financial Institutions Group

• Read the “User Control Considerations” portion of
the report
• Describes what is expected of your organization in
order for the controls to be effective
• If they say you must reconcile or review a report daily,
you must reconcile or review that report because there
are not sufficient controls on the vendor side to
prevent errors or misstatements

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What Does It Mean? Financial Institutions Group

• Your vendors should have controls in
place meeting your minimum
requirements by policy
• For example:
If you require 8 alphanumeric
characters in passwords that expire
every 30 days, make sure the vendor
requires at least the same, if not
stronger passwords. Don’t fall for “we
let you decide how strong the
passwords must be.” If it isn’t required
by the software, your risk increases
that weak passwords will be used.

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Reference Guide Financial Institutions Group

• A “Quick Reference Guide to SOC Reports” from
the AICPA is available. Please contact Doeren
Mayhew with your email, and we will send you a
PDF version.

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Compliance Learning Opportunities

37

HMDA - Regulation C – Home Financial Institutions Group
Mortgage Disclosure Master
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• Exam findings around HMDA LAR (Loan
Application Register) filing
• Financial institutions should implement a scrub process
of their HMDA LAR quarterly before filing annually to
eliminate errors
• CMP (Civil Money Penalties) being assessed for
incorrect HMDA LAR filing
• Documentation of application date from loan files needs
to be consistent

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Compliance Management Financial Institutions Group
System (CMS)edit Master
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• Implementation, development and maintain a
sound compliance management system that is
integrated into the overall risk management
strategy of the institution

• Board and management oversight is imperative

• Documentation of complaints

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Equal Credit Opportunity Act – Financial Institutions Group
Regulation to edit Master
Click B title style
• Maintain documentation of 30 day communication
with borrower on loan files

• Reconcilement of credit report inquiries
• Determine if all credit report pulls are valid and
disclosed to borrower

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RESPA – Regulation X Financial Institutions Group

• Exam findings on completion of Good Faith
Estimate, Service Provider List, and HUD. Forms
are not being completed correctly or in their
entirety

• Focus on understanding/completion of forms

41

Brokered Loans (RESPA) Financial Institutions Group

• Imperative to have formal agreements with
mortgage brokers, annual due diligence, and
statement of fees on file

• Brokered loan files need to include written
documentation/communication between the
institution, the bank, and the borrower to eliminate
any confusion on fees assessed

42

Fair Lending Financial Institutions Group

• Establish strong underwriting guidelines when
deciding loan applicants
• Create formal fair lending compliance and
monitoring program to mitigate risk of discrimination
• Financial institution should perform comparative
analysis of denied and approved loans with similar
underwriting characteristics
• Create a formal monitoring program to track denials
and exceptions

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Bank Secrecy Act (BSA) Financial Institutions Group

• High Risk Customers/Members
• Complete enhanced due diligence should include purpose of
account, activity, and monitoring of suspicious or large
transactions
• Money Service Businesses
• Complete due diligence annually to include onsite visits,
monitoring business activity, verifying registration with
FinCEN
• Non-Filed Suspicious Activity Reports (SARs)
• Retaining all documentation for SARs that are not filed

44

Unfair or Deceptive Acts or Financial Institutions Group

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Practices (UDAP) title style
• Implement policy and procedures to include
overdraft presentment of debit items
• To be included in customer/member disclosures
• Full disclosure of all fees
• No underlying fees charged to customer/member
• Direct advertising
• Not to include misleading information, rates, fees,
promotions
• UDAP covers full product line (deposit/lending)

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Affiliate Due Diligence Financial Institutions Group

• Financial institutions need to monitor third-party
relationships
• Credit reporting
• Appraisers
• Brokers
• Implement policy and procedures for third-party
relationships to include (annually):
• Due diligence
• Creating approved lists
• Annual auditing of third parties

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SAFE Act Financial Institutions Group

• Implement policy and procedures for SAFE Act
• Annual audit of the SAFE Act by third party
• Annual renewal of the institution and Mortgage
Loan Officers (MLOs) annually
• MLO numbers listed individually and publically

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Thank You!
Texas: Michigan: Florida:
One Riverway, Suite 1200 305 West Big Beaver Road 6750 North Andrews Avenue
Houston, Texas 77056 Troy, Michigan 48084 Suite 200
Ft. Lauderdale, Forida 33309

Robin D. Hoag, CPA, CGMA, CMC
Shareholder
Phone: 713.789.7077
Cell: 248.709.1270
Email : hoag@doeren.com

48

Contact Us Financial Institutions Group

Texas Financial Institutions Group

Catherine Bruder,
Bob Parks, CPA CPA, CITP, Joseph Zito, CPA, MBA
Shareholder CISA, CISM Shareholder
Financial Institutions Shareholder Financial Institutions
Group Financial Institutions Group
713.789.7077 Group 713.789.7077
parks@doeren.com 713.789.7077 zito@doeren.com
bruder@doeren.com

Jeremy Smith, CPA Geoff Gallo, ChFC, CExP
Manager Vice President of Sales
Financial Institutions Financial Institutions
Group Group
713.860.0255 713.860.0247
smith@doeren.com gallo@doeren.com

49

Services Financial Institutions Group

• Audit • Commercial loan review
• Merger & consolidations • Loan loss & delinquency
• IT assurance control
• Controls review • Regulatory compliance
• Vulnerability assessments
• Penetration testing

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Financial Instrument Credit Losses FASB Exposure Draft

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