Pub. 5 2015-2016 Issue 4

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 2015 21 Contact us today at 303.860.0242 or refer a small business anytime at coloradoenterprisefund.org Knotty Tie Company Offering loans up to $500K including SBA Community Advantage loans up to $250K Adam Mustafa is a co-founder of Invictus and has been providing stress testing, capital adequacy advisory and M&A services to banks, regulators, bank investors, and bank D&O insurers since the beginning of the financial crisis. Prior to joining Invictus, he had senior-level experience as a banker, financial services consultant and corporate CFO. He has an MBA from Georgetown University and a BA from Syracuse University. for the life of a loan, the term and structuring of a loan would take on greater import. Take two identical CRE loans. Imagine everything about them is the same, including that they both include 20-year amor- tization schedules. However, one of the loans has a maturity date at the end of the fifth year, while the other one is fully amortizing and matures at the end of the 20th reserve. 20th year. In that scenario, the second loan will require a greater reserve since the principal is outlaid for a longer period of time. (The ironic part is one could argue that the first loan has more refinancing risk, perhaps making it a riskier loan). If the second loan requires a greater reserve, then it is a less capital effi loan. This will incentivize you to either (i) shorten the length of the loan or (ii) look to get something in return from the borrower such as a higher interest rate on longer-term loans. This is just one example. The bottom line is that banks will have to become even more cognizant about how they structure loans moving forward because they will have a direct impact on loan loss expenses. This has strategic implications because competitive conditions may limit your ability to control the terms with borrowers.  CECL’s Road to Implementation and its Potential Effect on the Economy BY RYAN ABDOO, PLANTE MORAN With FASB’s Financial Instruments Project expected to be finalized in the first quarter of 2016, the new current expected credit loss model (CECL) is on the minds of all of us in the financial institutions industry. One area of focus remains the requirement to forecast expected losses and how an institution is going to support that forecast. As with anything new, the first few reporting periods are likely to be filled with uncer- tainty and debate among regulators, auditors, and manage- ment. But could there also be an overall concern with the potential impact on the general economy? Back in the “old days” of calculating the allowance for loan loss, the industry’s primary ratio of considerationwas the al- low- ance for loan losses as a percentage of loans. And with that ratio, wasn’t it amazing how so many institutions had some- where around 1.25 percent of total loans in the allowance? Well, that ratio probably wasn’t a coincidence, as regula- tory capital provisions include a formula that served as the baseline for that ratio. Under the former and current capital adequacy rules, banks are allowed to include the allowance for loan losses up to 1.25 percent of risk weighted assets in capital. Many in the industry expect that allowance for loan losses will need to be substantially increased as a result of CECL. The question that remains is whether the regulatory agen- cies will provide a form of relief. If that doesn’t happen, and allowances are required to significantly increase upon adop- tion of the CECL standard, some institutions and, potentially the industry as a whole, could be affected with the instant removal of all that capital from the market. The question that remains is whether the regulatory agencies will provide a form of relief. The industry and even the overall economy could face head- winds as institutions evaluate the effect of the new require- ments and how they will ensure they maintain compliance with the capital standards set forth by BASEL III. While banks await the final standard, they can still start thinking about implementation based on the draft proposal. Here are some questions to consider: • How will the loan portfolio be segmented to create pools with at least two similar credit risk characteris- tics? • Howwill the vintage of loans be factored into the loan pools? • What data is available to estimate the average life of the loans within the identified pools? • How will historical loss data be determined and tracked for each loan pool? • Howwill credit losses be estimated for each pool?While not a requirement, is the institution • positioned to develop and implement a probability of default model or migration analysis model? • What economic data can be gathered to help support the economic cycles within the institution’s lending area, com- mensurate with lending activities? 