Banks Queasy about Data, Guidance as Loan Loss Change Arrives

The theory sounded simple: make banks consider future losses and past lending experiences when calculating what they expect to lose on their loans.

Then came the hard part: actually doing it.

To prepare for what’s been billed as the biggest bank accounting change in decades, banks have dug through years of paperwork on old loans, filled in holes in that information when they didn’t have the right records, pulled full-time employees from their regular tasks, and hired outside experts to prepare for the current expected credit losses (CECL) accounting standard that takes effect for most large banks in January.

“This is probably the biggest change that, in my almost 40-year career, we’ve had to work through,” said John Morrow, chief accounting officer at the Bank of Oklahoma, which had to sift through 15 years of data to overhaul how it tallied losses.

Adding to the workload is the challenge of applying an accounting standard that’s big on principles and scant on specifics. Any time an accounting standard calls for judgment, companies and auditors need to back up their reasoning. This puts pressure on finding reliable data from numerous sources and forecasts that banks can use to make what’s considered one of the most sensitive estimates on their balance sheets.

“The whole thing is one big, wild guess,” said Peter Bible, chief risk officer at Eisner Amper LLP.

All in a Judgment

Banks can’t just take guesses, though, especially for a material estimate about loan losses that could lower their earnings if they have to beef up the reserves they set aside to cover credit losses in quarterly reports next spring.

Considered the Financial Accounting Standards Board’s chief response to the 2008 financial crisis, the new accounting requires banks and other businesses to look to the foreseeable future, assess current conditions, and consider past experience to make a “reasonable and supportable” assessment of their losses.

It reverses decades-old rules that require banks to not tally losses until there’s strong evidence a loss has happened—typically after a customer has missed payments or even defaulted. It’s supposed to make banks book losses sooner than they do now and offer investors and analysts better insight into credit quality and bank lending practices.

Results will vary. JP Morgan Chase & Co. expects to increase its loan loss reserve by $4 billion to $6 billion while Wells Fargo & Co., banking on collecting money from customers it had previously written off, expects to reduce its loss reserves by up to $2.5 billion.

FASB has offered examples and a few pieces of guidance on how to make the calculation without issuing hard-and-fast rules on how to comply with the new accounting.

Data, Data, Data

A bank’s internal loss rates are an important piece of the puzzle—past patterns of failed loans can help bankers make predictions about the future.

But while many banks have old records on hand, they may lack historical data covering highs and lows in an economic cycle, given how long ago the last recessions occurred. Some loan portfolios may be too small or experience too few losses to provide statistically meaningful data.

Even banks with the right data may find it spread across multiple computer systems or in formats that aren’t easily searchable. Field names, for example, change over time or between systems, making comparisons difficult.

Many banks brought in outside experts to help fill in the gaps from loan portfolios to economic data. Some signed up with software solutions to pull together all the pieces needed to calculate the CECL estimate.

Banks have to ensure that the data from those outside vendors is reliable and subject to the proper level of controls, as if the bank was the original source of the information, said Troy Vollertsen, who leads the banking audit practice for Deloitte & Touche LLP.

“Ultimately, the thing you have to keep in mind as management, is overall, the estimate is your number,” Vollertsen said. “All the inputs are things that are essentially your responsibility. You have to have processes and procedures to be comfortable.”

Questions over the reliability of outside data was one of the reasons the Bank of Oklahoma decided to go its own way and not hire a software vendor. Many vendors kept details about how they came up with their numbers in a “black box,” Morrow said.

“If there is one big industry concern from an auditing perspective, it is data from third party service providers,” said Graham Dyer, partner in Grant Thornton LLP’s accounting principles group.

Strength in Numbers

Auditors began meeting with vendors in April to address those concerns. They wanted to see the vendors’ calculations and understand how the model was put together, said Jason Brodmerkel, staff liaison to the Depository Institutions Expert Panel—a task force of the American Institute of CPAs that organized the meetings.

Many of the vendors that took part said they had already performed, or planned to seek, a technical audit of their system’s internal controls (known as SOC testing) to provide assurance over how the data was compiled, Brodmerkel said.

Although the tests will help alleviate some questions, auditors will need to know where the underlying data came from and how clients will know they can rely on that data, Dyer said.

Another tactic to address reliability of the data is to turn to familiar sources like Moody’s or S&P Global for help with economic projections and as well as historic loan and loss data. The best way to establish that a forecast is reasonable is to rely on the same data that other banks will use, said Jared Benedict, a technical accounting consultant for MorganFranklin who works with banks to implement CECL.

Sagar Teotia, chief accountant for the Securities and Exchange Commission, has said previously that the SEC would accept well-reasoned, and well-documented, judgments. The SEC issued a road map to help bankers meet that bar in November.

Not everyone is focused on the data. The real challenge is building a more rigorous process to meet a brand new set of accounting rules with little guidance from the standard-setter, said Tom Patterson, a Virginia CPA who has audited banks and credit loss estimates, whose work now focuses on risk management and internal controls.

He compared the hand-wringing to the stress of complying with the rollout of 2002’s 2002 Sarbanes-Oxley Act, the post-Enron accounting reform law.

“Right now it’s all suspect, because no one’s done it,” Patterson said.