Most financial institutions are preparing to implement the Financial Accounting Standards Board Accounting Standards Update (FASB ASU) related to Financial Instruments – Credit Losses. To help in that preparation, PYA has crafted this Insight with guidance for a specific part of the update: the treatment of off-balance-sheet credit exposure related to unfunded commitments, such as lines and letters of credit. The ASU introduces the current expected credit losses (CECL) model, which requires financial institutions to estimate, at the time of origination, the losses expected to be realized over the life of the loan. How does this concept translate to unfunded commitments?
The Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration, and the Office of the Comptroller of the Currency (the joint agencies) issued a series of FAQs. Among them, Question 9 sheds some light on this topic:
- Will there be an allowance for credit losses on off-balance-sheet credit exposures under CECL?
For off-balance-sheet credit exposures, an institution will estimate expected credit losses over the contractual period in which they are exposed to credit risk. Similar to today’s practices, an institution will report in net income as an expense the amount necessary to adjust the allowance for credit losses on off-balance-sheet credit exposures, which is reported as a liability, for management’s current estimate of expected credit losses on these exposures. For the period of exposure, the estimate of expected credit losses should consider both the likelihood that funding will occur and the amount expected to be funded over the estimated remaining life of the commitment or other off-balance-sheet exposure.
In contrast, the FASB decided that no credit losses should be recognized for off-balance-sheet credit exposures that are unconditionally cancellable by the issuer. To illustrate, Bank A has a significant credit card portfolio, including funded balances on existing cards and unfunded commitments (i.e., available credit) on credit cards. Bank A’s cardholder agreements stipulate that the available credit may be unconditionally canceled at any time. When determining the allowance for expected credit losses, Bank A estimates the expected credit losses over the estimated remaining lives of the funded credit card loans. However, Bank A would not evaluate or record an allowance for unfunded commitments on credit cards because it has the ability to unconditionally cancel the available lines of credit.
PYA Takeaways and Insights:
- For any arrangements that have unfunded portions that are unconditionally cancellable by the financial institution, no reserve would be required.
- For other unfunded commitments, the calculation will be more straightforward. The financial institution will multiply the unfunded balance by the likelihood of the amount being funded (expressed as a percentage) and then multiply that amount by the loss factor related to the specific loan category. The trickiest part will be establishing the likelihood of the amount being funded. This will require the financial institution to evaluate and accumulate additional data (i.e., historical funding patterns for the commitments, the time period the amount is available, and also take into account supportable forecasted information).
- The financial institution will be able to leverage the reserve factors its CECL model is indicating for the funded portions of loan categories when establishing the unfunded reserves.
- Unfunded portions of construction loans will have a high probability of being funded. As such, reserves for the unfunded portion are anticipated to have a similar factor/rate to what the financial institution’s CECL model indicates for the loan classification to which the construction loan is anticipated to convert once permanent financing has been established.
- The reserves established for unfunded commitments will not be reported as part of the allowance for loan and lease losses; they will continue to be reported as other liabilities.
How PYA Can Help
If you have questions about the implementation of this ASU or the CECL model, or if you would like assistance with any matter involving audit and assurance, business advisory, or regulatory compliance, one of our executive contacts would be happy to assist. You may email them below, or call (800) 270-9629.