The Financial Accounting Standards Board (FASB) is finalizing rules that will impact the way community financial institutions calculate the amount of money they’ll have to set aside for loan loss reserves.

Essentially, the board is moving from a model that bases allowance for loan losses on incurred credit losses to a model that bases that figure on current expected credit loss model.

“Under the new standards, they want you to look at the future, what is going to happen or what we think is going to happen. … That’s a little bit more difficult to do, because nobody really has a crystal ball,” said Giuseppe “Joe” Femia, G.T. Reilly & Co.’s director of financial institution advisory and assurance services.

He said it’s more likely that “an institution is going to take a valuation-type approach to determining what their loan losses are going to be; so, as of today, what do you think you’re going to lose in the future on these loans?”

Or in the FASB’s own language: “Under the proposal, management would be required to estimate the cash flows that it does not expect to collect, using all available information, including historical experience and reasonable and supportable forecasts about the future.”

The FASB has been working on this guidance for some time, and the forthcoming rules, which are expected to be released late this year, are a product of the financial crisis and ensuing economic downturn, born of a desire to hold financial institutions to a greater standard of transparency.

But the new guidance could also pose some difficulties for community banks and credit unions already struggling with sometimes onerous regulatory and accounting requirements, in large part because the new model would lean more heavily on management’s judgment than would an incurred loss model.

“I would say probably the most significant challenge is trying to determine how to estimate what those expected credit losses will be,” said Jean Joy, a member of the Boston-based firm Wolf & Co. and director of the firm’s financial institutions practice. “That’s because you can project into the future and the further you go into the future, the less accurate your projections can be. Finding methodologies that institutions will be comfortable projecting in the future is the challenge.”

Different Assumptions

And different types of loan portfolios will require different assumptions, too. You wouldn’t calculate the loan losses on a largely homogenous pool of residential mortgages the same way you would a portfolio of commercial real estate and commercial and industrial loans, for instance.

“I think the challenge we’ll have as auditors gets directly back to the term used in the standard: ‘supportable forecast,’” said John Leonard, who oversees Wolf & Co.’s credit union practice. “The expected losses that will now be part of the allowance for loan loss will be based on history, plus supportable forecast, so our clients will be preparing supportable forecasts as the rationale for the allowance. From our perspective, we have to get comfortable with those assumptions.”

Femia also raised the question of whether regulators would make exceptions for one-time capital adjustments made under the new rules, so that a bank’s capital position doesn’t take a hit when it gets up to speed with FASB’s new guidance.

“Usually the regulators follow the FASB and GAAP,” he said. “This may be a case where the regulators need to make an exception.”

Not Flying Blind

Lest you worry the board is expecting financial institutions to fly blindly into the darkness, the final guidance will also include some guidance for implementation, Joy said.

While big money-center banks with loads of resources and people at their disposal have been working on forecasting models for some time now, community banks and credit unions are largely taking a wait-and-see approach.

“I think for community banks, we’re basically all looking toward the final standard for the implementation guidance,” she said.

Leonard added that he’s seen a number of tech companies marketing canned software products and models to meet that need, as well.

Meanwhile, Femia was hopeful that FASB might yet tweak the final guidance. In particular, he would like to see the board allow non-public financial institutions a little bit more lead time to implement the rules. Typically, he said, those institutions might get a two- to three-year timeframe to implement the new rules.

“Usually an SEC or a publicly traded bank has more finance and loan resources, where community banks and credit unions may be leaning more on their auditors to help and may not have as much time to deal with this,” he said, adding that he would wait until the final guidance is released to talk to his clients about implementing those rules.