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Cecl's Implications for Bank Profitability, 13 System THE CONVERGENCE OF RISK, FINANCE, AND ACCOUNTING: CECL VOL 8 | NOVEMBER 2016 FEATURED ARTICLES: CECL’S IMPLICATIONS FOR BANK PROFITABILITY, 13 SYSTEM STABILITY, AND ECONOMIC GROWTH Potential effects and modeling options CECL SURVEY RESULTS 33 Banks’ challenges in preparing for CECL MAXIMIZING STRESS TESTING INVESTMENT 74 Strategic capital analysis Reserves Data Forecast AssetsEBA CECL Banks Life of Loan Modeling Accounting Exposure IFRS 9 DFAST Finance Accounting Reporting Impairment dards Risk Data The Fed Stan Peer Analysis Banks CCAR Assets Regulation Compliance FASB AIRB Risk FROM THE EDITOR Welcome to the eighth edition of Risk Perspectives™, a Moody’s Analytics working groups with representation from risk, accounting, treasury, finance, publication created by risk professionals for risk professionals. technology, and front-line business. Proactive firms will use the opportunity to revisit their data management and analytical platforms, looking for still-elusive This edition continues the theme started in the previous one – convergence of “straight-through” processing analytics, workflows, and overlay management. risk, finance, and accounting disciplines. After much delay and re-deliberation, the Financial Accounting Standards Board issued its new impairment standard, With this in mind, our first section throws the spotlight on the new standard Financial Instruments – Credit Losses, commonly known from a range of perspectives. Mike McDonald and Seung as the current expected credit loss (CECL) approach. Lee review the current state and near-terms plans in the Since it is hailed as the biggest change in bank CECL industry survey. Emil Lopez discusses similarities accounting, we would be remiss if we did not devote and differences between CECL and IFRS 9 impairment. an edition to the US version of the IFRS 9 impairment Daniel Brown and Craig Peters remind readers of the standard. stringent requirements on model risk management for CECL models. Cristian deRitis and Deniz Tudor look at With staggered implementation of the standard industry-wide implications of the new standard. David beginning in 2019, one may be inclined to postpone Kurnov and Vainius Glinskis look at the impact of the planning. That kind of thinking may prove to be a costly impairment standard on structured security portfolios – mistake. As Confucius said, “Real knowledge is to know something that often gets lost when firms focus on loan the extent of one's ignorance.” By most estimates, book impact first. We also review intersections of the the new standard will result in an increase in overall new impairment standard and Basel capital rules in the allowance balances and may cause increased volatility article written by Julien Temim, and Shirish Chinchalkar in period-to-period provisions. Implementation of the looks at a bottom-up approach to modeling retail new regulation will test practitioners and regulators mortgages. as the financial industry seeks to understand the full effect of the changes. Impact assessments vary widely In Principles and Practices, Nancy Michael, Avinash and the industry is only beginning to understand the Arun, and Helene Page discuss small business lending questions that need to be answered. What are the in a follow-up to their spring edition article. Samuel appropriate approaches for each portfolio segment and what is the right level of Malone and Ed Young discuss an approach to gauge counterparty credit risk in segmentation, given a firm’s complexity and size? What are the data gaps and preparation for single-counterparty credit risk regulation. Brian Poi and Anthony how can we address them? What is the appropriate length of a reasonable and Hughes propose a different use case for peer industry data in strategic planning supportable forecast and how does this impact potential volatility of provisions? and stress testing. In Innovation Zone, Joy Hart and Nihil Patel propose a new approach to strategic capital analysis. And finally, in Regulatory Review, we Furthermore, incorporation of forecast information in what was previously a look at potential changes to Basel III with the much-publicized push toward backward-looking process presents challenges for auditors and risk managers standardized approaches in two articles by Richard Peterson and Jonathan Séror. alike. Additionally, like any process that affects financial statements, the new allowance calculation is subject to strict internal governance and controls. For We hope you enjoy the edition, and as always, please stay in touch. these reasons, parallel runs of six to 12 months in length will be critical. As one Anna Krayn banker observed, there are no “mulligans.” Editor-in-Chief One thing is clear: CECL compliance will be an interdisciplinary challenge. Senior Director and Team Lead, Capital Planning and Stress Testing Implementation of the new impairment standard will require cross-functional [email protected] EDITORIAL WEB CONTENT Mary Hunt Anju Govil Jeffrey Reiser MANAGEMENT Editor-in-Chief Anna Krayn Joy Hart Jonathan Séror Anna Krayn Mary Sitzenstatter David Little Dr. Anthony Hughes Julien Temim Meghann Solosy Katherine Pilnick David Kurnov Dr. Deniz Tudor Managing Editors Katerina Soumilova Seung Lee Ed Young Clemens Frischenschlager ADVISORY BOARD Ed Young Emil Lopez Katherine Pilnick Michael Adler Jing Zhang Dr. Samuel W. Malone SPECIAL THANKS Michelle Adler Copy Editor Michael McDonald Gus Harris Celia Chen Maria Grazul CONTRIBUTORS Nancy Michael Robert King Dr. Shirish Chinchalkar Avinash Arun Helene Page Salli Schwartz DESIGN AND LAYOUT Danielle Ferry Daniel Brown Nihil Patel Stephen Tulenko Clemens Frischenschlager Chun-Yu Huang Dr. Shirish Chinchalkar Dr. Craig Peters Maria Grazul Yomi Ikotun Dr. Cristian deRitis Richard Peterson Jacob Grotta Donna Martines Vainius Glinskis Dr. Brian Poi While we encourage everyone to share Risk Perspectives and its articles, please contact [email protected] to request permission to use the articles and related content for any type of reproduction. CONTENTS FROM THE EDITOR 1 Anna Krayn, Editor-in-Chief, introduces this Risk Perspectives edition and its focus on the convergence of risk, finance, and accounting functions. SPOTLIGHT: CECL New Impairment Model: Governance Considerations 8 By Daniel Brown and Dr. Craig Peters CECL’s Implications for Bank Profitability, System Stability, and 13 Economic Growth By Dr. Cristian deRitis and Dr. Deniz K. Tudor Mortgage Models for CECL: A Bottom-Up Approach 23 By Dr. Shirish Chinchalkar What Does the New Impairment Standard Mean for Structured 29 Finance Holdings? By Vainius Glinskis and David Kurnov CECL Survey Results 33 By Michael McDonald and Seung Lee CECL vs. IFRS 9 38 By Emil Lopez The IFRS 9 Impairment Model and its Interaction with the Basel Framework 40 By Julien Temim PRINCIPLES AND PRACTICES The Future of Small Business Lending 50 By Avinash Arun, Nancy Michael, and Helene Page Stress Testing and Strategic Planning Using Peer Analysis 57 By Dr. Anthony Hughes and Dr. Brian Poi Beyond the Regulation: Exploring an Innovative Tool to Gauge 67 Counterparty Credit Risk By Dr. Samuel W. Malone and Ed Young INNOVATION ZONE Maximizing Stress Testing Investment: Strategic Capital Analysis 74 By Joy Hart and Nihil Patel REGULATORY REVIEW Are Internal Credit Models for Structured Securities Going Away? 80 An Analysis of the Recent Basel Consultative Document By Richard Peterson Basel III Standardized Approach to Counterparty Credit Risk (SA-CCR): 85 Adoption and Implementation Status By Jonathan Séror BY THE NUMBERS 4 SUBJECT MATTER EXPERTS 88 CONNECT WITH US 92 GLOSSARY 94 BY THE NUMBERS 5 50% 3 The model risk management standards issued Firms may need to increase their ALLL by as CECL affects three groups of financial assets: more than five years ago by the Federal Reserve much as 50% over current levels when CECL is assets carried at amortized cost, purchased and OCC will be a key element for CECL implemented, although results will be driven credit-deteriorated assets, and available-for-sale implementation, same as for any quantitative by ultimate portfolio composition and current securities. risk management process. approach to loan and lease loss allowance. What Does the New Impairment Standard Mean New Impairment Model: Governance CECL’s Implications for Bank Profitability, for Structured Finance Holdings? Considerations System Stability, and Economic Growth Page 29 Page 8 Page 13 62% 5 40% 62% of surveyed banks expect to increase their Under CECL, entities must disclose credit A Moody’s Analytics survey found that more provisions as a result of CECL implementation. quality indicators for a period of up to five years, than 40% of respondents planned to integrate CECL Survey Results depending on the portfolio. IFRS 9 requirements into their existing Basel Page 33 CECL vs. IFRS 9 infrastructure. Page 38 The IFRS 9 Impairment Model and its Interaction with the Basel Framework Page 40 6 MOODY’S ANALYTICS RISK PERSPECTIVES 25% 85% $250b Small business loans constitute more than a In our industry balance sheet forecast model, The cutoff: Financial institutions with more quarter of the lending volume in the US. three principal components can account for than $250 billion in assets and more than $10 The Future of Small Business Lending more than 85% of the total variance of all the billion in foreign exposure must report net credit Page 50 macroeconomic variables. exposures to unaffiliated counterparties on a Stress Testing and Strategic Planning Using Peer
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