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New guidance: Credit risk review systems and allowances for credit losses

May 22, 2020 / 3 min read

Regulatory agencies issued new guidance on allowances for credit losses and credit risk review systems, superseding previous guidance from December 2006. Read on for details of these statements and what they mean for you.

On May 8, 2020, the Federal Deposit Insurance Corporation (FDIC) issued Financial Institution Letters (FILs) FIL-54-2020 and FIL-55-2020 summarizing the issuance by the Office of the Comptroller of the Currency, Federal Reserve Board, FDIC, and the National Credit Union Administration of the Interagency Policy Statement on Allowances for Credit Losses and Interagency Guidance on Credit Risk Review Systems, superseding the December 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses and related Attachment 1 – Loan Review Systems and NCUA’s May 2002 Interpretive Ruling and Policy Statement 02-3, Allowance for Loan and Lease Losses Methodologies and Documentation for Federally Insured Credit Unions.

The agencies adopted this policy statement in response to changes in the accounting for credit losses under U.S. generally accepted accounting principles (GAAP), and the new guidance was developed to align with existing guidance for establishing standards for safety and soundness. The principles described within the guidance are consistent with regulatory reporting requirements and apply to all FDIC-supervised institutions through the release of the FILs. The Interagency Policy Statement will take effect at the time of each institution’s adoption of FASB ASC Topic 326, Financial Instruments – Credit Losses, commonly known as “CECL,” which may be delayed in accordance with Section 4014 of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, whereas the Interagency Guidance on Credit Risk Review Systems is effective immediately.

Our view

Interagency Policy Statement on Allowances for Credit Losses

The agencies decided not to limit flexibility in implementing ASC 326 by narrowing options or defining terms not defined in GAAP. The Policy Statement does not endorse a specific loss estimation method or provide more detail about specific implementation choices, including providing templates for certain methods. The agencies note ASC 326 is intentionally flexible to permit variances in assumptions and determinations in estimating expected credit losses given an institution’s own unique set of facts and circumstances. This lack of bright line guidance over calculating and estimating these inherently imprecise allowances for credit losses is in the spirit of ASC 326.

In summary, institutions should continue to follow the best practice of “show your work” as it relates to the documentation of all facets of the process. Consistent application of appropriate methodologies, given an institution’s size and complexity with adequate management involvement and board oversight, is imperative to successfully implementing ASC 326 and the Policy Statement.

Interagency Guidance on Credit Risk Review Systems

The fundamental objectives of an effective risk rating system haven’t shifted as a result of the new interagency guidance from previous guidance and industry practices. Credit risk review systems continue to serve the same key objectives as identified above. Interagency guidance emphasizes the need to tailor the systems policies, procedures, and practices based on multiple factors of the institution in order to ensure that the system in place is effective. This guidance updated and clarified information included in Attachment 1, including language to be consistent with the current expected credit losses methodology.

The goal of the credit risk review system is to support safe and sound credit risk management. This is achieved through the development, execution, and monitoring of the framework. By using an institution’s staff, management, board, external third parties, or a combination thereof, the system supports the independent and ongoing review of credit risk, which is communicated timely to management and the board of directors.

In summary, we believe the guidance was issued to provide financial institutions with practical and scalable elements that are essential pieces of the credit risk review systems and overall risk management practices. The guidance outlines the objectives of the credit risk review system, elements of an effective credit risk rating, and the credit risk review framework. Current industry practices and examples are incorporated into the guidance to assist institutions in the development and application of the framework.

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