CECL Prep: Key Changes and Crafting an Implementation Plan. · be as expected. Sageworks is not responsible for the accuracy or validity of this publicly available industry data,

CECL Prep: Key Changes and Crafting an Implementation Plan.May 16, 2016

P R E S E N T E D B Y

Aaron LenhartSenior Risk Management ConsultantSageworks

Disclaimer.This presentation may include statements that constitute “forward-looking statements” relative to publicly available industry data. Forward-looking statements often contain words such as “believe,” “expect,” “plans,” “project,” “target,” “anticipate,” “will,” “should,” “see,” “guidance,” “confident” and similar terms. There can be no assurance that any of the future events discussed will occur as anticipated, if at all, or that actual results on the industry will be as expected. Sageworks is not responsible for the accuracy or validity of this publicly available industry data, or the outcome of the use of this data relative to business or investment decisions made by the recipients of this data. Sageworks disclaims all representations and warranties, express or implied. Risks and uncertainties include risks related to the effect of economic conditions and financial market conditions; fluctuation in commodity prices, interest rates and foreign currency exchange rates. No Sageworks employee is authorized to make recommendations or give advice as to any course of action that should be made as an outcome of this data. The forward-looking statements and data speak only as of the date of this presentation and we undertake no obligation to update or revise this information as of a later date.

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About Sageworks.

Agenda.• What is CECL?

• Recent Updates & Timelines

• Forming An Implementation Committee

• Importance of Risk Rating

• How to Prepare

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What is CECL?• FASB released proposal December 2012

• CECL = Current Expected Credit Loss

• What’s changed from Incurred Loss Model?» Forward-looking requirements» “Probable loss” threshold removed» Need for accessible, loan-level data» Longer loss horizon» Makes ALLL more institution-wide calculation

• Purpose: Quicker recognition of losses. Changes in ALLL reserve balances will reflect changes in credit quality and flow through earnings (“Fed Perspectives,” 2015)

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CECL Concerns.• How are future, life-of-loan losses reasonably predicted?

• Even more subjective judgment is required

• Greater regulatory scrutiny

• Insufficient IT capabilities

• Lack/inaccessibility of data, especially for smaller credit unions

• Need to know where we are in the economic cycle

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CECL Concerns.• Implies we can identify when a downturn/recovery starts

• Implies we can predict the severity of a downturn

• Discourages longer-term lending

• Qualitative factors – Will need to consider both current and future conditions

• Requires more collaboration between Credit/Finance

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CECL Concerns.• More difficult for members receiving financial statements to

understand the financials of their credit union

• Decreased capital because of the increased provisions for loan loss

• Lack of adequate historical figures to construct a model to forecast expected losses accurately

• Potential for lower net income levels

Source: “CUs tell FASB: CECL plan brings excessive costs, decreased capital” CUNA, March 23, 2016

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Recent CECL Updates.

Feb. 4 FASB Industry Roundtable.• Participants from FASB, NCUA, ABA, ICBA, SEC, OCC, Fed, FDIC +

more than a dozen financial institutions from $145M to $1.1B

• Participants were critical of the “life of loan” concept and voiced a need for more definitions and better examples

• CUNA President Jim Nussle, following the meeting » “To be clear, CUNA does not believe the CECL model is appropriate

for credit unions, and we believe the accounting changes of the standard will severely increase credit unions’ allowances…”

» “[The proposal] will result in lower apparent capital ratios at credit unions and banks.”

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CECL Transition Resource Group.• Members announced on March 22nd:

» SVP, CFO of Jeanne D’Arc Credit Union | $1.1B in assets» CFO at Mission Federal Credit Union | $2.7B» EVP of TD Bank | $246B» VP, Chief Accountant at BMO Financial Group | $104B» Director of Accounting Policy at Wells Fargo | $1.6T» Managing Director at Citigroup | $1.3T» SVP at First Niagara Bank | $39B» President, CEO at Standard Bank | $466M

• Also, representatives from:» Allstate Insurance, KBW, PWC, Grant Thornton, Crowe Horwath,

Deloitte, KPMG, EY

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April 1st Meeting, CUNA Highlights.

• Proposal’s revised language provides additional flexibility, stating that there is no one methodology that entities must use

• Susan Hannigan noted the revisions are “progress toward a workable solution”» Allows community financial institutions to evaluate and adjust

their loan-loss amounts using qualitative factors, historical losses and current systems

• Final standard expected by the middle of the year

• Specifics on the proposal’s revised language?

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CECL Implementation Timelines.

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Implementation Planning.Forming an Implementation Committee

Scope of CECL Implementation.

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Operational CreditLegal/

Compliance

•Credit Business Lines

•Mergers & Acquisitions

•Counter-parties

•IT Systems•Vendor Management

•Regulatory Reporting

•Financial Reporting

Forming An Implementation Committee.

• Look at how the allowance calculation flows through your credit union and how many areas touch it

• Strive for senior level representation across all departments

• CECL will require significant collaboration across functional areas

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CECL Committee

CFO

Risk Officer

Audit

IT

Workout

Head of Credit

/Lending

Factors to Consider.

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Methodology Changes

Data Requirements

Capital Adjustment

Communication

Projected Impact

Historical loss to migration, PD/LGD, vintage analysis

“Reasonable and supportable forecasts”

Life of loan expected loss versus one year incurred loss

Model validation

Internal controls

External provider


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Methodology Changes

Data Requirements

Capital Adjustment

Communication

Projected Impact

Building and maintaining a data warehouse

Assessing availability and quality of historical data

Determining key data needed for calculation

Data validation process

Report building process


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Methodology Changes

Data Requirements

Capital Adjustment

Communication

Projected Impact

Need to raise additional capital?

Member communication

Regulatory communication

Timing consideration


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Methodology Changes

Data Requirements

Capital Adjustment

Communication

Projected Impact

Socialization of CECL with board and senior management

Periodic meetings

Documents read into the minutes


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Methodology Changes

Data Requirements

Capital Adjustment

Communication

Projected Impact

Earnings projection due to changes in provision

Peer comparisons will change

Asset and liability management

Stress testing

Loan pricing

Underwriting guidelines

Segment lending limits

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Implementation Planning.Strengthening Risk Rating Procedures

Risk Rating Systems.

• Forms the basis for broader risk management practices:» Risk-based loan pricing» Calculating the reserve» Stress testing» Strategic planning for the institution

• Insight into portfolio risk for:» Management team» Board» Auditors

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Internal System Requirements.

1. Granular – Number of ratings will depend on the credit union’s portfolio, but should be sufficiently granular that loans do not pool in one or two ratings.

2. Transparent – Credit union staff and examiners should be able to review and distinguish between risk ratings. Both parties should be able to risk rate a loan independently and arrive at the same rating.

3. Objective – The risk rating matrix will only be valuable if the personnel responsible for risk rating a loan are external to the lending process (someone other than the lender, for example).

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Determining a Risk Rating Scale.

• Total number of ratings will vary, anywhere from 5 to 10 grades

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PASS SPECIALMENTION

SUB-STANDARD DOUBTFUL LOSS

1 2 3 4 5 6 7 8 9Largely risk free Low risk Minimal

riskModest

riskAddition-al review Criticized Classified Classified Classified

The granularity in pass loan categories is where credit unions

typically differ

Determining a Risk Rating Scale.

• More commonly, loans are pooled in too few categories

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PASS SPECIALMENTION

SUB-STANDARD DOUBTFUL LOSS

1 2 3 4 5 6 7 8 9Largely risk free

Lowrisk

Minimalrisk

Modestrisk

Addition-al review Criticized Classified Classified Classified

Establishing Rating Criteria.

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Dimensions

Capacity

Debt Service Coverage (Proposed & Historical)Interest CoverageSensitivity of the Business to Change in IncomeSensitivity to Interest Rate RiskBusiness Credit ScoreLease Terms / Customer Base

CapitalCurrent RatioDebt to EquityTangible Net Worth

CollateralLoan to ValueCollateral Quality (variability of value, easy to liquidate)

ConditionsMember’s SkillsIndustry Performance (Current ratio, DSC, NPM)Comparison to Industry (Financial & Product Line)

CharacterMember’s Financing AlternativesManagement of the BusinessGuarantor's Credit Score (and others?)Tangible Net Worth of Guarantors

Factors

Building a Matrix.

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Capacity35%

Proposed Debt Service Coverage 20%Historical Debt Service Coverage 20%

Sensitivity of the Business to Change in Income 10%

Sensitivity to Interest Rate Risk 10%Business Credit Score 10%Lease Terms / Customer Base 30%

Capital15%

Current Ratio 40%Debt to Equity 40%Tangible Net Worth 20%

Collateral 10%Loan to Value 25%Collateral Quality 75%

Conditions15%

Member’s Skills 20%Industry Current Ratio 20%Industry DSC 20%Industry NPM 20%Comparison to Industry 20%

Character25%

Member’s Financing Alternatives 25%Management of the Business 25%Guarantor's Credit Score 25%Tangible Net Worth of Guarantors 25%

Calculating Risk Rating Score.

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RAW SCORE WEIGHT RAW SCORECAPACITY __________ X 35% =______________

CAPITAL __________ X 15% =______________

COLLATERAL __________ X 10% =______________

CONDITION __________ X 15% =______________

CHARACTER __________ X 25% =______________

Final Raw Score

= ______

1 2 3 4 5 6 7 8 9<151 151-

230231-310

311-380

381-450

451-500

501-540

540-571

>570

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CECL Prep: What to do Now.

CECL Poll.

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12%

32%45%

1% 10%

When will you start CECL preparations?Prior to enforcement date When CECL is finalizedAlready planning When examiners require itDon't know

2016: Create Roadmap.

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Key Action Items• Build committee• Set project plan• Review final CECL language• Inform board & management of committee/ALLL changes• Examine data/current processes

Key Takeaways.• Minimize risk in loans you’re underwriting today

• Avoid the temptation of simply adapting your current methodology

• Reduce dependency on spreadsheets

• Start cross-department conversation now, including Credit and Finance

• Review/strengthen risk rating procedures

• Capture, archive and incorporate loan-level detail into the ALLL

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Contact Information & Questions.Aaron LenhartSenior Risk Management Consultantaaron.lenhart@sageworks.com866.603.7029www.sageworksanalyst.com

2016 Risk Management Summit• Sept. 14-16 in Austin, TX• ALLL & Stress Testing Conference• www.sageworks.com/summit

CECL Prep: Data Guide• web.sageworks.com/CECL-Prep-Guide-Data/

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