Welcome to the eighth edition of Risk Perspectives™, a Moody’s Analytics publication created by risk professionals for risk professionals.
This edition continues the theme started in the previous one – convergence of risk, finance, and accounting disciplines. After much delay and re-deliberation, the Financial Accounting Standards Board issued its new impairment standard, Financial Instruments – Credit Losses, commonly known as the current expected credit loss (CECL) approach. Since it is hailed as the biggest change in bank accounting, we would be remiss if we did not devote an edition to the US version of the IFRS 9 impairment standard.
With staggered implementation of the standard beginning in 2019, one may be inclined to postpone planning. That kind of thinking may prove to be a costly mistake. As Confucius said, “Real knowledge is to know the extent of one's ignorance.” By most estimates, the new standard will result in an increase in overall allowance balances and may cause increased volatility in period-to-period provisions. Implementation of the new regulation will test practitioners and regulators as the financial industry seeks to understand the full effect of the changes. Impact assessments vary widely and the industry is only beginning to understand the questions that need to be answered. What are the appropriate approaches for each portfolio segment and what is the right level of segmentation, given a firm’s complexity and size? What are the data gaps and how can we address them? What is the appropriate length of a reasonable and supportable forecast and how does this impact potential volatility of provisions?
Furthermore, incorporation of forecast information in what was previously a backward-looking process presents challenges for auditors and risk managers alike. Additionally, like any process that affects financial statements, the new allowance calculation is subject to strict internal governance and controls. For these reasons, parallel runs of six to 12 months in length will be critical. As one banker observed, there are no “mulligans.”
One thing is clear: CECL compliance will be an interdisciplinary challenge. Implementation of the new impairment standard will require cross-functional working groups with representation from risk, accounting, treasury, finance, technology, and front-line business. Proactive firms will use the opportunity to revisit their data management and analytical platforms, looking for still-elusive “straight-through” processing analytics, workflows, and overlay management.
With this in mind, our first section throws the spotlight on the new standard from a range of perspectives. Mike McDonald and Seung Lee review the current state and near-terms plans in the CECL industry survey. Emil Lopez discusses similarities and differences between CECL and IFRS 9 impairment. Daniel Brown and Craig Peters remind readers of the stringent requirements on model risk management for CECL models. Cristian deRitis and Deniz Tudor look at industry-wide implications of the new standard. David Kurnov and Vainius Glinskis look at the impact of the impairment standard on structured security portfolios – something that often gets lost when firms focus on loan book impact first. We also review intersections of the new impairment standard and Basel capital rules in the article written by Julien Temim, and Shirish Chinchalkar looks at a bottom-up approach to modeling retail mortgages.
In Principles and Practices, Nancy Michael, Avinash Arun, and Helene Page discuss small business lending in a follow-up to their spring edition article. Samuel Malone and Ed Young discuss an approach to gauge counterparty credit risk in preparation for single-counterparty credit risk regulation. Brian Poi and Anthony Hughes propose a different use case for peer industry data in strategic planning 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 look at potential changes to Basel III with the much-publicized push toward standardized approaches in two articles by Richard Peterson and Jonathan Séror.
We hope you enjoy the edition, and as always, please stay in touch.
Senior Director and Team Lead, Capital Planning and Stress Testing