Pub. 10 2020-2021 Issue 5

O V E R A C E N T U R Y : B U I L D I N G B E T T E R B A N K S — H E L P I N G C O L O R A D A N S R E A L I Z E D R E A M S January • February 2021 19 under the CECL standard, the borrower must be experiencing financial difficulties. Therefore, for each impaired loan with collateral, you must determine that the borrower is experiencing financial difficul - ties currently and on an ongoing basis to continue to classify the loan as a collateral dependent. Determin- ing what borrower statistics qualify to determine that the borrower is “experiencing financial difficulties” is important to this conclusion. Could past due status be an indicator of financial difficulties? Yes, but what happens when the borrower becomes current again? Moving a loan in and out of collateral dependent status may be cumbersome based on past due status alone. Institutions need to develop policies that de- fine when a loan meets the standard’s requirements. Since this part of the standard is a practical expe- dient, not required, we recommend using collateral dependent only when pool modeling is significantly underestimating the expected loss. • As a secondary requirement of the practical expedi- ent, if the borrower is “experiencing financial diffi - culties,” the loan’s repayment must be substantially provided through the collateral’s operation or sale to apply the collateral dependent method to a collat- eralized loan. FASB does not define “substantially.” However, the dictionary defines substantially as “con - siderable in quantity.” Each institution will have to consider how they evaluate this subjective definition. FASB also does not define “through the operation of.” In general, this indicates that the asset’s revenue would cover the repayment of the loan. • A loan that does not fit into a risk pool can be evaluat - ed individually as a final option. To be clear, you CAN NOT use the fair value of collateral to indicate the estimated loss. Individually evaluating a loan would require an analysis of the borrower’s ability to meet the cash flow needs of the loan and forecast borrower specific risks into the future economic environments, just like pool loans. The author believes this method takes significantly more effort than other methods. During FASB deliberations, a bank CEO in a meeting with FASB commented that all 1,500 of his commercial loans were different and did not fit into a pool struc - ture. FASB staff commented that they could perform 1,500 individual loan forecasts with varying risk profiles if that were the case. That is not a functional or practical option! The author believes the concept of “substantially” here is critical because if the loan is not repaid substantially through the collateral sale or operation, it would not fit the definition. It is not unusual for loans to stay on nonaccrual for periods longer than 90 days in the community bank environment. Leaving a loan in collateral dependent status for a long time is in stark contrast to the concept behind collateral depen- dent loans within the CECL standard. Why? Because the calculation is based on current collateral value, and collateral value can change significantly over time. Also, the longer you hold a loan in this status, it calls into question whether the borrower is having financial difficulties and why the institu - tion has not taken action to sell the asset. C onverting Purchase Credit Impaired Loans (PCI) In general, current impaired loans are classified as such because the borrower is having financial difficulties as of the current period. However, PCI loans are classified when purchased and, in many cases, if the loan survives for a period of time on the institution’s ledger, without charge off or re-underwriting, the presumption of “having financial difficulty” may not apply when the loan is converted to PCD under CECL. Under current purchase accounting guidance, loans im- paired on the purchased institution ledger generally become PCI loans under the acquirers’ purchase accounting entries. At purchase, these loans typically have a credit mark and a premium or discount mark applied in determining fair value at purchase. Since all PCI loans need to be converted to PCD upon conversion to CECL, each PCI loan allowance will need to be recalculated based on a CECL method and applied to each loan in converting to a PCD loan. The allowance at con- version would be calculated in one of three ways. 1. If the borrower is “not experiencing financial difficul - ties,” then the allowance could be calculated either as (i) part of the risk pool the loan belongs to or (ii) indi- vidually if the loan does not fit into a risk pool. Either method requires historical analysis and forecasting cash flows into the future. 2. If the loan is in foreclosure or probable foreclosure, the initial allowance would have to be calculated using the collateral’s fair value. 3. If the borrower is “experiencing financial difficulties,” then the allowance could be calculated based on the fair value of collateral less related expenses. In adjusting the PCI accounting-related values to PCD related accounting values, the net effect will be zero and, therefore, will not be part of the CECL capital adjustment. A decrease or increase in the PCI credit mark to a CECL allow- ance would correspond to an equivalent adjustment to the discount or premium on the respective loan. Because these conversions only happen at adoption, we recommend that the current impaired loans and PCI loans be reviewed, but do not make the conversions until the adoption date. For most institutions, the effect of the conversion would not be material. However, if the institution has significant PCI loans with significant credit marks, the institution needs to analyze the borrowers to determine if they qualify as collateral dependent. Many of our larger institutions that have significant PCI pools have found that the conversion of the remaining credit marks to a CECL allowance have been material and, in many cases, have resulted in a reduction of the amount allocated to credit risk. As your institution moves toward CECL adoption, there are many facets of the new CECL standard that will require significant effort and planning. Understanding how your in - stitution will operationalize the adoption and adjusting your policies and procedures will require an understanding of all of the CECL requirements to be successful. n