Corporate Governance, Best Practices for Small and Non-Complex Financial InstitutionsCorporate Governance
Supervisory guidance1 allows CECL methodologies to be scalable and appropriate to a financial institution’s size and complexity. Many smaller and less complex institutions can build out their previously used allowance methods to meet the requirements of the new accounting standard without the use of costly and/or complex modeling techniques. For many institutions that will mean updating and maintaining spreadsheets in order to prepare calculations for the allowance for credit losses (ACL) under their chosen methodology. While some may employ a third-party vendor to assist in completing the calculations, this article focuses on in-house practices. Regardless of the choice made, all institutions should have an appropriate governance structure in place to ensure accurate financial and regulatory reporting and maintain records consistent with safe and sound banking practices.
Board Involvement and Interdependencies
Good corporate governance begins with an active and well-informed board of directors. The board, or a designated committee there of acts in an oversight of management. Board oversight activities may include the following:
- retaining experienced and qualified management to oversee all ACL and provisions for credit losses (PCL) activities;
- reviewing, approving, and periodically monitoring the institution’s written loss estimation policies;
- reviewing management’s assessment of:
- the loan review system and management’s conclusion and support for whether the system is sound and appropriate for the institution’s size, complexity, and risk appetite;
- the effectiveness of processes and controls for monitoring the credit quality of the investment portfolio; and
- support for the estimated amounts reported each period in the institution’s financial and regulatory reports, requiring management to periodically validate, and when appropriate, revise loss estimation methods; approving the internal and external audit plans for the ACLs, as applicable; and reviewing any identified internal and external audit findings and findings identified by supervisors and monitoring resolution of those items.
Director oversight of management’s efforts should be timely and be supported by reports that are in sufficient detail for directors to be reasonably informed. Directors should also incorporate the assistance of outside parties as appropriate such as their audit firms and data service providers.
Management should be aware that many activities are interrelated and may be impacted by CECL. These may include Finance/Treasury, Accounting/Financial Reporting, Internal Audit, Credit/Risk (including securities and loans), Credit Review functions and Information Technology (IT)/Information Security (IS). A written plan for transition to CECL is a good idea, but the plan need not be overly complicated or burdensome. It may include the following:
- identifying owners for key activities associated with CECL
- creating a structure for owners to make periodic reports on how CECL impacts their activities, including budgets, training and implementation of internal controls
- establishing implementation steps and timelines for meeting objectives
- establishing a process for follow-up as needed including testing and revising policies and procedures
Policies and Procedures
An institution’s ACL written policies and procedures should be appropriately tailored to an institution’s size and complexity. These may address, but not be limited to:
- identifying roles, responsibilities, and segregation of duties of an institution’s personnel that are involved in estimation and review of ACLs;
- identifying ACL methodology (or methodologies) and key data and assumptions used in calculations including historical data and adjustments for qualitative factors and forward-looking information
- methods for segmenting financial assets based on similar risk characteristics;
- procedures for the validation of the loss estimating process, including any adjustments from prior periods; and
- satisfactory internal controls to ensure the ACL is in accordance with GAAP and interagency guidelines for safety and soundness.
An institution’s management is responsible for establishing and maintaining an effective system of controls. Internal controls should be periodically tested by an independent party who reports either directly to the institution’s board or its designated committee. Smaller and less complex institutions whose size and complexity do not warrant a full-scale internal audit function may rely on regular reviews of essential internal controls conducted by other institution personnel that are independent of the activity that is reviewed.
In addition, good corporate governance practices over internal controls should:
- provide assurance regarding the relevance, reliability, and integrity of data and information used in estimating expected credit losses;
- provide reasonable assurance of compliance with laws, regulations, and internal policies and procedures;
- provide reasonable assurance that the institution’s financial statements are prepared in accordance with GAAP, and the institution’s regulatory reports are prepared in accordance with the applicable instructions;
- include an effective loan review and credit risk grading process; and
- include an effective process for monitoring credit quality in the debt securities portfolio.
Given the importance of appropriate internal controls to institutions of all sizes and risk profiles, the results of audits or reviews, whether conducted by an internal auditor or by other personnel, should also be adequately documented, as should management’s responses to any findings.
The ability to control data quality is essential for accurate financial and regulatory reporting; and management information systems. If you have bad data, it likely results in bad loss estimates. For many institutions, the adoption of CECL requires a more extensive use of data compared to incurred loss methodologies.
Historical lifetime loss estimates and forecasting elements likely require institutions to expand the collection of current data sets. For example, to forecast the potential losses of a 30-year mortgage, an institution may need accurate historical data from when the loan was originated, prepayment expectations, and robust forward-looking data that allow to establish trends that could point to what will happen with that mortgage over its life.
Institutions need to identify which specific factors are most applicable to them. For example; when identifying changes in economic conditions between historical and current or future periods, an institution might look to historical and forecasted regional and national unemployment data. Borrower-specific factors might include changes in industry conditions if borrowers are concentrated in specific industries (e.g., construction, agriculture, heavy manufacturing, oil and gas). It may be important to monitor recent changes in the borrower’s financial metrics (e.g., debt service coverage ratio, net income to sales, or debt to EBITDA) to see whether these indicate that adjustments may be necessary to historical loss experiences for commercial borrowers.
As discussed in the Interagency CECL FAQs (FAQ #16), the agencies encourage institutions to discuss the availability of historical loss data internally with lending, credit risk management, information technology, and other functional areas and with their core loan service providers.
While some of the required data may have been previously subject to some validation, all data used in the allowance estimation process should be controlled and tested, not just as part of the initial adoption, but also on an ongoing basis. The data quality checks should be implemented at multiple points through the entire data pipeline from systems of origin to data preparation/aggregation. This will ensure that a continuous monitoring is embedded in the allowance calculation process.
Data subject to validation includes both historical loss information (from either internal sources, external sources, or a combination of both) and forward-looking information, such as changes in unemployment rates, delinquency, or other factors associated with the financial assets (from internal sources, external sources, or a combination of both).
A best practice calls for institutions to establish an appropriate process or program to review data that is used in establishing and maintaining the allowance for credit losses. This program may be formalized to the extent justified by the institution’s size and complexity or be less formal if the institution data handling practices are simple. Such a program might include:
- written policies and procedures;
- written expectations of roles and responsibilities;
- monitoring and reporting processes;
- end-to-end data integrity controls; and
- audit assessment.
As noted before, the new accounting standard is scalable to institutions of all sizes, which means that smaller and less complex institutions can meet the requirements of this new accounting standard without the use of costly and/or complex modeling techniques.
Management should ensure methodologies align with market and portfolio composition. The CECL methodologies selected should be relevant to the institution’s specific market and the portfolio’s composition, as different estimation methods may be applied to different groups of financial assets. For example, loss data for home mortgages would not be appropriate to support loss factors for subprime auto.
Financial and Regulatory Reporting
To verify that ACL balances are presented fairly in accordance with Call Report instructions, management may prepare a document that summarizes the amount to be reported in the financial statements and regulatory reports, which includes the following information:
- reasonable and supportable economic forecasts used;
- estimate of the expected credit loss for each category of assets evaluated;
- amount, if any, by which ACL balance was adjusted; and
- narratives and sub-schedules that supports the ACL estimate.
There may be instances in which individual officers or committees that review ACL methodology and resulting allowance balances identify adjustments that need to be made to the loss estimates to provide a better estimate of expected credit losses.
These changes may occur as a result of holistically evaluating the individual components of the estimation process and considering the overall estimate of ACL as a whole or due to information not known at the time of the initial loss estimate. It is important that these adjustments are consistent with GAAP and are reviewed and approved by appropriate personnel.
SR Letter 20-12, Interagency Policy Statement on Allowances for Credit Losses, issued May 8, 2020 sets forth guidelines for the establishment and maintenance of allowance for credit loss estimates for all supervised financial institutions.