In just a matter of months, the coronavirus pandemic has had an unprecedented impact on the economy, upending financial institutions’ 2020 goals and business strategies. Now, banks and credit unions across the country must be nimble, making the necessary adjustments to meet the needs of the institution and its customers and members amid the pandemic. Between the economic slowdown, emergency rate cuts, and an ambiguous future economy, financial institutions have found themselves on the defensive.
One area of concern for financial institutions is their approach to consolidation as they navigate an uncertain economy. A recent Abrigo survey revealed that three out of five institutions considering mergers and acquisitions are putting their plans on hold. While activities like M&A may be paused in the short-term, financial institutions can use this time as an opportunity for other areas of consolidation, such as consolidating vendors and systems in order to achieve a more efficient and informed decision-making process. One area of consolidation that can pay dividends in the future is by connecting CECL and valuation calculations. Relating these functions allows for more effective, credible, and consistent results, all of which will put financial institutions in stronger strategic positions.
Misconceptions of relating valuation calculations and CECL
Explicit reconcilements between fair value estimates and allowance calculations are inappropriate. However, relationships exist, and comparisons may help management and third parties achieve higher levels of assurance. As expected with any new accounting standard or process, misconceptions are prevalent.
One common misconception is that credit mark and CECL are equal. It is rational to expect life-of-loan credit loss estimates to be similar; however, there are very good reasons for such estimates to differ. First, fair value estimates are indicative of market participants’ expectations of credit loss, while CECL estimates are management’s best estimate of their own credit loss. Second, fair value standards limit inputs and assumptions to known or knowable information, whereas CECL requires the use of future conditions and reversion to long-term averages. Finally, the modeled life of each loan is different due to inputs and renewal/extension assumptions resulting in varying exposures later in life. Valuations often include renewal and extension assumptions, but CECL prohibits the assumed extension of any credit that isn’t expected to be a Troubled Debt Restructure (TDR).
Another frequent misconception is the belief that discount rates are the same for fair value and CECL. The intention of a discount rate for valuation purposes is to present future cash flows as a value relative to market conditions. This often includes considerations for risk-free opportunities, capital requirements, liquidity, and uncertainty estimates. In contrast, the intention of a discount rate for CECL purposes is to isolate credit risk. In practice, the ideal discount rate results in a present value equal to the cost basis when no defaults or losses are assumed (zero allowance). Once defaults and/or losses are assumed, the difference between present value and the cost basis isolates lost principal and interest.
Challenges of relating fair value and CECL
The relationship between fair value and the allowance has changed. Particularly for acquisitive institutions, there are real implications stemming from the CECL model application, vendor selection, and valuation processes. When executed thoughtfully, the implications can be understood and minimized.
Under the incurred loss model (450-20), an allowance wasn’t recorded for newly acquired assets. Purchased Credit Impaired (PCI) instruments were accounted for under 310-30 (SOP 03-3), which required maintenance of a separate allowance account (‘impairment’), periodic cash flow estimations, and periodic re-yielding/impairment analysis. Additionally, instruments that were not identified as PCI were considered to have an adequate allowance due to the credit component included in the fair value adjustment. Because of this interpretation, there was no allowance recorded for non-PCI instruments until the estimated allowance exceeded remaining discount. Even then, the allowance generally reflected the shortfall only.
Now, reserves are required on Day 1, which can be a challenge for some financial institutions. This means that newly-acquired loans will need to be included in allowance models and their reserve reflected on the balance sheet. Whether the reserve is recognized through a provision expense on the income statement or merely a balance sheet entry is determined by the instruments’ Purchased Credit Deteriorated (PCD) designation: PCD = balance sheet while non-PCD = income statement.
The solution, as we see it, is relatively simple: CECL and valuation calculations should be done in the same environment by those familiar with the implications of these decisions. Ideally, prior to the close date, the acquiring institution should have a notional valuation, a notional CECL calculation, and both should be operable models going forward. For example, when one of our clients announces an acquisition, we prepare their CECL models for ongoing calculations while simultaneously preparing preliminary valuation estimates as well as their Day 1 valuation. This practice not only assists with the operational burden of standing up an allowance model, but it also prepares management with critical expense and/or payback intelligence.
Another challenge that arises when relating CECL and fair value is the variance between exit price disclosure and Day 1 valuations. The fair value disclosure isn’t new, but the requirement to use an exit price notion is new with the introduction of ASU 2016-01. When different modeling assumptions, different vendors, or different models are used relative to the Day 1 valuation, difficult and unexplainable differences may arise. During this transition period, we’ve seen disclosure presentations reflecting wildly different fair value estimates with only days separating the two calculations.
One simple solution is to use the same model and process for Day 1 valuations and exit price disclosures. Of course, the same model would result in the same answer given the same ‘as-of’ date.
There are distinct differences between fair value and CECL calculations. However, there are distinct similarities as well, and navigating both requires domain knowledge and thoughtfully built systems. Clients that have partnered with Abrigo for CECL and valuation services will be well-positioned to address these new challenges. Most importantly, Abrigo clients won’t be surprised on Day 1 or Day 2.
Despite the challenges associated with adjusting long-term strategic initiatives, banks and credit unions have a unique opportunity to consider ways to make more informed, data-driven decisions amid coronavirus implications. Consolidating key systems and processes that aggregate data, like CECL modeling results and fair value, can give decision makers easier access to data and a more comprehensive view of the financial ecosystem, which will maximize the chances for successful strategic decisions. Given the current competitive landscape and economic challenges, any advantage is worth exploring.