How Has CECL Adoption Affected Credit Loss Allowance Levels?

In the movie “50 First Dates,” Drew Barrymore’s character Lucy suffers from anterograde amnesia, which prevents her from forming new memories after a brain injury she sustained during a car accident. Once Lucy discovers that her family has been playacting the day of the accident — her father’s birthday — every day since her memory loss to avoid telling her about her condition each day, she feels betrayed. Adam Sandler’s character, Henry, is a newcomer in Lucy’s life, and he helps her connect with the present by creating videos for her to watch each morning that explain the accident, her amnesia, and what her life is like now, including his presence in it. Until recently, financial institutions were a bit like Lucy when it came to calculating loan loss reserves — letting past data drive their decisions. Yet, just like the videos Henry makes for Lucy to help her take in new information about her life trajectory, the introduction of the Current Expected Credit Losses (CECL) accounting standard requires affected institutions to turn away from historical data and instead look to the future for their calculations. CECL, which became effective for SEC filers in 2020 and for all other banks in 2023, requires banks to calculate an Allowance for Credit Losses (ACL) based on estimated future losses, not losses incurred in the past. Banks must now record an appropriate lifetime loss reserve whenever financial assets are added to the balance sheet, instead of setting aside reserves only when future losses appear likely.Differences Between Small and Large CFIsAccording to data compiled by the Federal Reserve Bank of Kansas City, CECL adoption has resulted in an average increase of 3.76% in the ACL of all community financial institutions (CFIs). However, there are considerable differences in how adoption has impacted CFIs with less than $1B in assets and those with assets between $1B and $10B, with larger CFIs reporting more substantial increases.According to the data, CFIs with under $1B in assets reported an average ACL increase of 3.08%. This compares to a 7.53% average ACL increase for CFIs with between $1B and $10B in assets. It’s noteworthy that approximately two-thirds of CFIs reported either no change or a reduction in ACL due to CECL adoption. The vast majority of them (nearly 92%) were CFIs with under $1B in assets. One possible explanation for the less pronounced impact of CECL on smaller institutions is their heavier usage of qualitative factors prior to CECL implementation. This helped smaller CFIs maintain higher ACL coverage ratios.By contrast, larger CFIs usually have a larger proportion of consumer credit portfolios, such as mortgages and credit cards. These consumer products have shown to be subject to larger ACL increases under the new CECL standard, in line with their longer terms, volatility, and historical loss rates, compared to the equivalent products smaller CFIs have with small and mid-sized businesses.Digging Deeper into the DataThe data appears to indicate that CECL adoption has had a less profound impact on smaller CFIs than larger ones. However, the reality isn’t quite this simple. CECL has not necessarily been harsher on large institutions; instead, the data reflects the differences in portfolio composition and pre-existing accounting practices between small and large CFIs.According to the Federal Reserve’s Economic Research, CECL adoption has led to more timely loan loss provisions that better reflect local economic conditions for CFIs of all sizes. Institutions disclose longer, more forward-looking, and more quantitative loan loss information and have fewer loan defaults after adopting CECL. Not surprisingly, larger institutions have seen more significant improvements due to their ability to invest more technology resources and human capital in CECL-related information systems. CFIs of all sizes should stay engaged with the evolving accounting standards of the banking industry and their broader implications on portfolio management and risk. PCBB offers a tool that can help your institution comply with CECL by estimating your ACL: CECL FIT®. This web-based solution offers transparent reporting to help you mitigate your CECL-related risk. Plus, our experts are available to assist.