CECL Near and Far But Not Too Far

CECL – Near and Far (But Not Too Far) Lara Lylozian, Acting Chief Accountant Board of Governors of the Federal Reserve System Paul Oseland, CPA Supervising Examiner – SRM Accounting Specialist

Disclaimer The opinions expressed in this presentation are intended for informational purposes and are not formal opinions of, nor binding on, the Board of Governors of the Federal Reserve System or the Federal Reserve Bank of Kansas City.

CECL Refresher

Key Differences

Key Similarities • Charge-offs (write offs) will continue to be recorded in the period in which the amount is deemed uncollectible • CECL doesn’t affect cash flows. • Non-accrual practices are not addressed in the new standard • Continue to follow existing regulatory guidance • Consideration of both qualitative factors and quantitative factors is required • Guidance for determining a TDR is unchanged

CECL - Scope * Under the new credit loss model for AFS, credit losses will be recorded through an allowance ** No change to current GAAP PCD^ Allowance for purchased credit deteriorated (PCD) financial assets is determined in a similar manner; however, initial allowance is added to purchase price rather than as a provision expense

Day 1 Impact – SAB 74 Disclosures Institution Bank of America Corp. Citigroup Inc. CECL Impact 20% Notes NA 20% - 30% Plan to use single macro forecast JP Morgan Chase & Co. 35% Driven by cards. Will use 2 year forecast Wells Fargo & Company -15% Decrease for commercial, increase for consumer. Include recoveries related to residential mortgages that were previously written down. Discover Financial Services 55% - 65% NA U. S. Bancorp 25% - 35% NA

Impact Generalizations • CECL impact estimates are all over the board, including a few banks that expect the Allowance to decrease. • Impact depends on composition of the portfolio • Short-term, high quality loans (C&I) may result in lower allowance • Longer-term and consumer loans tend to increase the allowance • Credit cards are especially affected by CECL • Day 1 change in the ACL may not correlate to ongoing provision expense • Sallie May is reporting an estimated CECL impact of +280%

CECL Hot Topics • “Negative Reserves” due to expected recoveries • Really a contra to a contra-account • “Double Counting” related to non-PCD loans and securities • Could significantly impact earnings of an acquiring bank • Incentive to push for PCD treatment may result in a paradox when the multiple is high yet a substantial portion of the portfolio is designated as purchased credit deteriorated

“Negative Reserves” Example: Bank A buys a portfolio of non-performing consumer loans (>180 days PD) for an amount which it believes to be collectible, which is $200 M. The face amount of the debt is $1, 000 M. Journal Entry #1 - record the acquisition: General Ledger Account Loans Debit Credit $1, 000 M Allowance For Credit Losses $800 M Cash (consideration paid) $200 M

“Negative Reserves” Journal Entry #2 – record the loan charge-off in accordance with the Uniform Retail Credit Classification and Account Management Policy: General Ledger Account Debit Provision Expense $200 M Allowance For Credit Losses $800 M Loans Credit $1, 000 M Journal Entry #3 – record the net amount expected to be collected: General Ledger Account Allowance For Credit Losses Provision Expense Debit Credit $200 M

“Negative Reserves” Net Journal Entry: General Ledger Account Loans Debit Credit $1, 000 M Allowance For Credit Losses $800 M Cash (consideration paid) $200 M Provision Expense $200 M Allowance For Credit Losses $800 M Loans Allowance For Credit Losses Provision Expense $1, 000 M $200 M

PCD Accounting Example: Bank A pays $1. 5 MM for a pool of PCD loans with an outstanding balance of $2 MM. The difference is attributable to yield ($150 M) and credit ($350 M). General Ledger Account Loans Debit Credit $2, 000 M Loan Discount (Yield) $150 M Allowance For Credit Losses $350 M Cash (consideration paid) $1, 500 M Takeaway: there’s no income statement impact, and no “nonaccretable difference” to be accounted for.

Non-PCD Accounting Example: Bank B pays $1. 9 MM (fair value) for a pool of non-PCS loans with an outstanding balance of $2 MM. The difference is attributable to yield ($100 M), but the bank also expects future credit losses of $80 M General Ledger Account Loans Provision Expense Debit Credit $2, 000 M $80 M Loan Discount (Yield) $100 M Allowance For Credit Losses $80 M Cash (consideration paid) $1, 900 M Takeaway: booking the “day one” provision could significantly impact current earnings

FASB’s Response • This is an old issue for the FASB and has been addressed in prior exposure drafts and deliberations • Are the loans really non-PCD? Purchased Financial Assets with Credit Deterioration: Acquired individual financial assets (or acquired groups of financial assets with similar risk characteristics) that as of the date of acquisition have experienced a more-than -insignificant deterioration in credit quality since origination, as determined by an acquirer’s assessment.

Other CECL Developments ASU 2018 -18, Codification Improvements • Transition and Effective Date for Nonpublic Business Entities • Mitigate transition complexity by requiring that nonpublic business entities implement CECL for fiscal years beginning after December 15, 2021, including interim periods within those fiscal year. • Operating Lease Receivables • Clarifies that receivables arising from operating leases are not within the scope of CECL • Instead, impairment of receivables arising from operating leases should be accounted for in accordance with Topic 842, Leases.

Other CECL Developments ASU 2019 -04, Codification Improvements to Topic 326, Financial Instruments – Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments • Accrued Interest • Permits entities to measure the allowance for credit losses on accrued interest balances separately and to make an accounting policy election to: • Not measure the allowance for credit losses on accrued interest receivable balances if an entity writes it off in a timely manner • Write off accrued interest balances by reversing interest income or recognizing credit loss expense, or a combination of both • Present accrued interest receivable balances along with any allowance separately on the financial statements • Also allows entities to elect a practical expedient to separately disclose accrued interest balances as a single balance to meet disclosure requirements • Transfers between Classifications or Categories for Loans and Debt Securities • Requires reversal of any previously recorded allowance for credit losses when a loan or debt security is transferred to a new classification or category

Other CECL Developments ASU 2019 -04 (continued) • Recoveries • Clarifies that recoveries of amounts written-off or expected to be written-off should be included when measuring the allowance for credit losses • For collateral dependent financial assets, the allowance for credit losses that is added to the amortized cost basis should not exceed amounts previously written-off • Projections of Interest Rate Environments for Variable-Rate Financial Instruments • Allows entities to use projections of future interest rate environments when measuring expected credit losses on variable-rate instruments. • Entities should also adjust the effective interest rate using the same assumptions for projects of future interest rate environments and expected prepayments. • Consideration of Prepayments in Determining the Effective Interest Rate • Allows entities to make an accounting policy election to adjust the effective interest rate for expected prepayments • Consideration of Estimated Costs to Sell when Foreclosure is Probable • Clarifies that estimated costs to sell are required to be considered (on an undiscounted basis) when an entity intends to sell rather than operate the collateral

Other CECL Developments ASU 2019 -05, Financial Instruments – Credit Losses (Topic 326): Targeted Transition Relief • Permits entities to elect the fair value option for financial instruments at adoption of ASU 2016 -13 Board Meeting – June 5 th, 2019 • Discussed “negative allowances” on PCD assets Board Meeting – October 18, 2019 • Approved its proposal to grant private companies, not-for-profit organizations, and certain small public companies effective date delay • SEC Filers that are not Smaller Reporting Companies – January 2020 • All other entities – January 2023

Regulatory Activities The banking agencies have been monitoring implementation efforts based on size and complexity • LISCC and Large Banking Organizations – CECL readiness assessments in coordination with the primary federal regulator • Regional Banking Organizations – CECL surveys and ad hoc discussions • Community Banking Organizations • CSBS, Fed, FDIC - CECL Questionnaires in conjunction with Safety & Soundness examinations • OCC – CECL questions as part of structured off-site monitoring

Regulatory Observations • General awareness and planning for CECL implementation is improving, albeit slowly • Readiness often correlates to size; smaller banks are lagging the larger institutions • Most bank still expect to use a loss rate methodology (including WARM) for at least a segment of the portfolio • There’s been an uptick in responses indicating intention to use thirdparty service providers • The agencies are neutral on the use of vendors, but outsourced risk management guidance will apply

Regulatory Observations • Many banks have fallen behind their implementation planning milestones, but not expected to impact readiness • Data availability continues to be a challenge • Less time for parallel runs • Day 1 impact is expected to be moderate, but depends on individual portfolio characteristics • Impact will change if economic conditions deteriorate • Reasonable and supportable forecast periods vary widely between one year and the life of the loan

CECL Regulatory Capital Transition Final Rule released on December 21, 2018 • Revises the capital rule to identify which credit loss allowances under CECL are eligible for inclusion in a firm’s regulatory capital • Incorporates the term “adjusted allowance for credit losses” (AACL) in the rule • AACL generally includes allowances related to assets measured at amortized cost. • Amounts of credit loss allowances includable in tier 2 capital remain unchanged. • Optional three-year phase-in of “day-one” impact on regulatory capital • The agencies are committed to closely monitoring the effects of CECL on regulatory capital and bank lending practices. • Amends the Board’s stress testing regulations to delay CECL inclusion until the 2020 stress test cycle.

FASB Resources - WARM Method On January 10, 2019 the FASB issued a Staff Q&A on the Weighted Average Remaining Maturity Method

FASB Resources - Developing an Estimate of Expected Credit Losses On July 17, 2019 the FASB issued a Staff Q&A on: • Historical Loss Information • Developing Reasonable and Supportable Forecasts • Reversion to Historical Loss Information

AICPA Resources • Practice Aid: Allowance for Credit Losses – Audit Considerations • Written for auditors, but will be useful for bank management as well • Covers internal control and governance issues • Outlines audit objectives and procedures • CECL Issue Papers • Examples and justification for zero expected credit losses • US Treasury securities, Ginnie Mae Mortgage-Backed securities, Agency Mortgage. Backed securities • CECL Issues Tracker

Agency Resources • Proposed Interagency Policy Statement on Allowances for Credit Losses published October 17, 2019 • Explains the measurement of allowances for credit losses under the CECL as well as the updates issued since June 2016 (collectively, FASB ASC Topic 326). • Describes regulatory expectations for • • designing, documenting, and validating CECL methodologies. maintaining appropriate allowances for credit losses under the new accounting standard. boards of directors and management. examiner reviews of allowances for credit losses. • Comment period expires December 16, 2019

Agency Resources • Ask the Regulator Webinars • Ask the Regulators: Applying Model Risk Management to CECL Models at Large Banks (August 3, 2019) • Ask the Regulators: CECL Webinar: Weighted-Average Remaining Maturity (WARM) Method (April 11, 2019) • Ask the Regulators: CECL Q&A Webinar for Community Bankers (July 30, 2018) • Ask the Regulators: Practical Examples of How Smaller, Less Complex Community Banks Can Implement CECL (February 27, 2018) • CECL Update: Frequently Asked Questions (October 3, 2017) • Frequently Asked Questions on the Current Expected Credit Losses Methodology (CECL) • SR 19 -8 issued April 3, 2019

Questions?