Pub. 5 2015-2016 Issue 4

20 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 FEATURE ARTICLES ADAM MUSTAFA RYAN ABDOO RICHARD MURPHY INVICTUS Bank Insights Possible Credit Loss Models under CECL ● Vintage ● Loss-rate methods ● Roll-rate methods ● Probability of default methods ● Provision matrix methods using loss factors ● Discounted cash flow methods measurements. SOURCE: FEDERAL RESERVE 2014 PRESENTATION Three Ways CEOs Should Ad- just their Strategic Thinking in the CECL-Era BY ADAM MUSTAFA, INVICTUS SENIOR PARTNER Bank CFOs across the industry are sitting on pins and needles waiting for the Financial Ac- counting Standards Board (FASB) to announce its overhaul to the accounting treatment for loan loss provisioning. In a nutshell, this revi- sion—the current expected credit loss model (CECL)— will mean less earnings for banks in the future. I will not join the cottage industry of consultants and SAAS compa- nies by opin- ing on why you should spend lots of money on technology to solve this problem. Instead, this article focuses on the impact of CECL on the CEO’s world. 1. The risk-reward trade-offof organic growth would take yet another hit. The heart of strategic planning is maximiz- ing this tradeoff The low interest rate envi- ronment, competitive conditions, and rising asset inflation has already made the risk/ reward tradeoff of making new loans far less attractive relative to historic standards. The cost of provisioning for bad loans will only exacerbate this – especially for longer-term real estate loans, which get penalized hard- er under CECL since the bank will have to provision for the “life of the loan.” Net net—new loans will require even more capital to support them (or depending on what camp you’re in, the high cost of cap- ital that already exists will become more transparent). As a result, other alternatives including M&A and returning capital back to shareholders will become more attractive by default. CEOs at the smartest banks are already looking for ways to quantify this so they can navigate the bank strategically in the way that creates the most shareholder value. 2. The smartest banks will benefi be- cause CECLwill reward those banks who grow at the RIGHT time. One of the biggest fallacies in banking is that growth is always good. In most indus- tries, growth is usually always good. Not in banking. Growth is good in certain environ- ments, and not in others. In general, growth is always best at the beginning of a business cycle, not the end of one. Consider the banks that grew rapidly in 2005-07. Banks that grew more in 2003-04, but slowed down around 2005, fared much better because they made few loans at the peak of the real estate bubble that eventually burst. In to- day’s environment, banks that grew more during 2009-11, when the economy was at the ‘bottom’ and in the early part of the recovery, actually made some very safe and resilient loans. Those loans also have very attractive interest rates. Banks with the right CECL tools will be rewarded since these loans need much less capital to support them. Banks that have been aggressively growing more recently will discover that loans closed over the last year or twowill requiremuchmore capital to support them because they were originated when economic conditions were at their post-crisis peak, meaning they have more downside risk. We’re back to the old adage of “the best loans are made in the worst of times” and vice versa. A good CECL model will capture this. From the CEO’s perspective, CECL can provide even more clarity to help deter- mine whether it makes sense to prioritize growth moving forward. For those banks that grew at the right times and pulled back fromgrowing at the wrong times, CECL will emerge as a powerful vehicle that quantifies the bank’s “story” to a CEO’s board, share- holders, creditors, and regulators. 3. You will need to adjust your strate- gy for structuring and pricing new loans. The intended and unintended consequences of CECL will result in greater loan loss ex- pensing for certain loans.Since CECL would require banks to reserve for expected losses