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Financial Instrument Credit Losses FASB Exposure Draft
 

Financial Instrument Credit Losses FASB Exposure Draft

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    Financial Instrument Credit Losses FASB Exposure Draft Financial Instrument Credit Losses FASB Exposure Draft Presentation Transcript

    • Click to edit Master title style 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 Click to edit Master title style• 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. 2
    • Financial Instruments ED Scope Financial Institutions Group Click to edit Master title style• 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. 3
    • Are trading securities and loans  Financial Institutions Groupheld for sale included?  Master Click to edit title style• 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. 4
    • Loss Models – Incurred Loss Financial Institutions Group Click to edit Master title style • 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. 5
    • Loss Models – Incurred Loss Financial Institutions Group Click to edit Master title style • 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. 6
    • Key Loss Concept Changes within  Financial Institutions Group Click to edit Master title stylethe 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.” 7
    • Model – Current Expected Credit Loss Financial Institutions Group Click to edit Master title style • 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. 8
    • Key Point: Definition of Expected Financial Institutions Group Click to edit Master title style • 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. 9
    • “Life of Loan” = “Expected” Financial Institutions Group Click to edit Master title style • “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) 10
    • “Life of Loan” = “Expected” Financial Institutions Group Click to edit Master title style 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) 11
    • Expected ALLL Model Financial Institutions Group Click to edit Master title style • “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? Source: American Bankers Association (ABA) 12
    • Expected Financial Institutions Group Click to edit Master title style • 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.” Source: American Bankers Association (ABA) 13
    • ALLL Processes Financial Institutions Group Click to edit Master title style • 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. 14
    • ALLL Processes Financial Institutions Group Click to edit Master title style • “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.” Source: American Bankers Association (ABA) 15
    • ALLL Processes  Financial Institutions Group Click to edit Master title style • 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. 16
    • ALLL Processes  Financial Institutions Group Click to edit Master title style • 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. 17
    • What Can We Expect For ALLL  Financial Institutions Group Click to edit MasterImpact 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. 18
    • Impact Expected for ALLL Financial Institutions Group Click to edit Master title style • 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 Groupcapital requirement implications Click to edit Master title style • 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 Click to edit Master title style– 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  Financial Institutions Groupaccounting and financial reporting?  Click to edit Master title style • 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  Financial Institutions GroupChange Improve Impairment Accounting?  Click to edit Master title style • 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  Financial Institutions Groupcapital requirement implications Click to edit Master title style • 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. 24
    • Number of Failed Banks Financial Institutions Group Click to edit Master title style 25
    • Number of Failed Banks Financial Institutions Group Click to edit Master title style 26
    • Click to edit Master title style Service Organization Control (“SOC”) Reports27
    • SOC 1, 2, and 3 Financial Institutions Group Click to edit Master title style• 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 1, 2, and 3 Financial Institutions Group Click to edit Master title style• 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 1, 2, and 3 Financial Institutions Group Click to edit Master title style• SOC 3 Report • Discusses security, availability, processing integrity, confidentiality, or privacy but does not include details about the controls. 30
    • Vendor Governance Financial Institutions Group Click to edit Master title style • 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 31
    • Vendor Governance Financial Institutions Group Click to edit Master title style • 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 Click to edit Master title style • 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 33
    • What You Should Know Financial Institutions Group Click to edit Master title style • 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 34
    • What Does It Mean? Financial Institutions Group Click to edit Master title style • 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. 35
    • Reference Guide Financial Institutions Group Click to edit Master title style • 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. 36
    • Click to edit Master title style Compliance Learning Opportunities37
    • HMDA - Regulation C – Home Financial Institutions GroupMortgage Disclosure Master Click to edit Act title style• 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 38
    • Compliance Management Financial Institutions GroupSystem (CMS)edit Master Click to title style• 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 39
    • Equal Credit Opportunity Act – Financial Institutions GroupRegulation 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 40
    • RESPA – Regulation X Financial Institutions Group Click to edit Master title style• 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 Click to edit Master title style• 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 Click to edit Master title style• 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 43
    • Bank Secrecy Act (BSA) Financial Institutions Group Click to edit Master title style• 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 Click to edit MasterPractices (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) 45
    • Affiliate Due Diligence Financial Institutions Group Click to edit Master title style• 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 46
    • SAFE Act Financial Institutions Group Click to edit Master title style• 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 47
    • Financial Institutions Group Click to edit Master title style 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 Financial Institutions Group Phone: 713.789.7077 Cell: 248.709.1270 Email : hoag@doeren.com48
    • Contact Us Financial Institutions Group Click to edit Master title style 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 Click to edit Master title style • Audit • Commercial loan review • Merger & consolidations • Loan loss & delinquency • IT assurance control • Controls review • Regulatory compliance • Vulnerability assessments • Penetration testing 50