Banking and Finance Law Daily Banking agencies issue guidance, policy statement on credit loss, credit risk review
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Monday, May 11, 2020

Banking agencies issue guidance, policy statement on credit loss, credit risk review

By Colleen M. Svelnis, J.D.

In response to updated FASB accounting standards, the federal banking agencies have issued a policy statement on credit losses and final interagency guidance for credit risk review in order to be consistent with the accounting standards change regarding the CECL methodology.

Because of a change in accounting standards, the federal financial regulatory agencies have revised the existing policies for the allowance for loan and lease losses. The Federal Reserve Board, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and National Credit Union Administration have approved a policy statement on allowances for credit losses (ACLs) along with final interagency guidance on credit risk review systems along with interagency guidance on credit risk review systems.

Updated accounting standards. In June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-13, which introduced the current expected credit losses (CECL) methodology and replaces the existing incurred loss methodology in U.S. GAAP. The FASB has codified these changes, including subsequent amendments. These are codified in Accounting Standards Codification Topic 326, Financial Instruments–Credit Losses (FASB ASC Topic 326).

The final guidance for credit risk review, which applies to all banking institutions, discusses sound management of credit risk, a system of independent ongoing credit review, and appropriate communication regarding the performance of the institution’s loan portfolio to its management and board of directors. The interagency policy statement describes the measurement of expected credit losses under the CECL methodology and the accounting for impairment on available-for-sale debt securities in accordance with FASB ASC Topic 326. The statement also includes and updates concepts and practices detailed in existing policy statements on the allowance for loan and lease losses that remain relevant under FASB ASC Topic 326. The guidance and statement apply to all financial institutions.

The interagency guidance is a stand-alone document that updates and replaces existing guidance on the elements of an effective credit risk review system. The interagency guidance highlights the important role of credit risk review systems in an institution’s overall risk management program.

Final guidance on credit risk review. In October 2019, the agencies invited public comment on proposed guidance on credit risk review that would update and clarify the interagency policy statement and adjust terminology to be consistent with the accounting standards change regarding the CECL methodology. The agencies received 19 comments on the proposed guidance. According to the agencies, many comments were in favor of the guidance, although some commenters "raised concerns including that the guidance was too prescriptive." A number of commenters expressed concern with what they viewed as the one-size-fits all approach of the proposed guidance, instead requesting that the agencies specifically tailor the guidance to emphasize flexibility based on an institution’s size or risk profile.

The final guidance includes "targeted changes and clarifications" to address the concerns raised by commenters.

In response to comments about the role of credit risk review, the agencies emphasize that credit risk review is a significant risk management function separate from the determination of the appropriate reserve for credit losses. The core responsibilities of a credit risk review system are discussed in the final guidance under the objectives of an effective credit risk review system, and include the prompt identification of loans with credit weaknesses and the validation and adjustment of risk ratings.

Commenters noted that the language in the proposed guidance stating that loans selected for credit risk review are evaluated for "sufficiency of credit and collateral documentation" was "too broad." The final guidance does not recommend that credit risk review perform or oversee the loan documentation process. However, the guidance notes that effective credit risk review often includes the evaluation of loan documentation as part of the overall assessment of the credit risk of a particular transaction. Thus, effective credit risk review assesses and evaluates information from departments responsible for loan documentation and highlights identified concerns in the reports to management, including recommendations for their resolution.

Several commenters raised questions about the frequency of credit risk reviews and requested clarification as to when it is appropriate for reviews to be conducted less frequently than annually. The agencies have clarified in the final guidance that an effective credit risk review system starts with a written credit risk review policy that is typically reviewed and approved at least annually.

Regarding the risk rating process, commenters requested that the proposed guidance clarify that an institution’s board of directors retains the responsibility for maintaining a bank’s credit risk rating and establishing relevant policies. Some commenters questioned whether the proposed guidance would require institutions to employ an arbitration process. The final guidance addresses risk rating differences between the credit risk review and areas responsible for loan approval. The final guidance also discusses a risk rating framework that is consistent with safe and sound practices and the agencies’ guidelines for supervisory classifications.

The proposed guidance was revised to state that effective communication typically involves providing results of the credit risk reviews to the board of directors or appropriate board committee quarterly.

The final guidance also includes language in a new bullet under the "Scope of Reviews" section, which acknowledges that institutions may determine the scope of the credit risk review by segmenting or grouping loans based on similar risk characteristics, such as those related to borrower risk, transaction risk, and other risk factors. The new bullet is intended to provide clarity and reflect existing industry practices for retail portfolios. The final guidance also includes language in a new sub-bullet under "Depth of Transaction Reviews." The sub-bullet indicates that, with regard to evaluating credit quality, soundness of underwriting and risk identification, borrower performance, and adequacy of the sources of repayment, "[w]hen applicable, this evaluation includes the appropriateness of automated underwriting and credit scoring, including prudent use of overrides, as well as the effectiveness of account management strategies, collections, and portfolio management activities in managing credit risk."

The agencies noted that the final guidance is intended to be flexible and consistent with CECL, but it does not incorporate FASB Topic 326. To provide further clarity and to emphasize the flexibility available to institutions, the agencies have modified the final guidance to read "evaluation of the institution’s historical loss experience for each of the groups of loans with similar risk characteristics into which it has segmented its loan portfolio."

The Fed’s Division of Supervision and Regulation issued a Supervisory Letter giving an overview of the guidance and its effects. The OCC has issued a Bulletin noting that the guidance requires rescinding OCC Bulletin 2019-48, "Current Expected Credit Losses: Notice and Request for Comment on Proposed Interagency Policy Statement on Allowances for Credit Losses." Additionally, the FDIC has issued a Financial Institution Letter on the interagency guidance.

Interagency Policy Statement on ACLs. The agencies have issued a final interagency policy statement on ACLs in response to changes to U.S. generally accepted accounting principles (GAAP) as promulgated by the FASB the interagency policy statement describes the measurement of expected credit losses under the CECL methodology and the accounting for impairment on available-for-sale debt securities in accordance with FASB ASC Topic 326; the design, documentation, and validation of expected credit loss estimation processes, including the internal controls over these processes; the maintenance of appropriate ACLs; the responsibilities of boards of directors and management; and examiner reviews of ACLs.

An OCC Bulletin on the policy statement, Current Expected Credit Losses: Final Interagency Policy Statement on Allowances for Credit Losses describes how the policy statement explains the measurement of ACLs under the FASB’s updated standards. The policy statement also describes the design, documentation, and validation of CECL methodologies; the maintenance of appropriate ACLs under the new accounting standard; the responsibilities of boards of directors and management; and the responsibilities of examiners when reviewing the ACLs. The policy statement will replace the two earlier OCC Bulletins when the updated accounting standard becomes effective for each bank. The two bulletins are OCC 2006-47, "Allowance for Loan and Lease Losses (ALLL): Guidance and Frequently Asked Questions (FAQs) on the ALLL," and OCC 2001-37, "Policy Statement on Allowance for Loan and Lease Losses Methodologies and Documentation for Banks and Savings Institutions: ALLL Methodologies and Documentation."

The FDIC has issued a financial institution letter explaining that the interagency policy statement:

  • describes the CECL methodology for determining ACLs on financial assets measured at amortized cost (including loans held for investment and held-to-maturity debt securities), net investments in leases, and certain off-balance-sheet credit exposures in accordance with FASB ASC Subtopic 326-20;
  • explains the estimation of an ACL for an impaired available-for-sale debt security in accordance with FASB ASC Subtopic 326-30; and
  • includes and updates concepts and practices detailed in the existing December 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses (2006 allowance policy statement) and July 2001 Policy Statement on Allowance for Loan and Lease Losses Methodologies and Documentation for Banks and Savings Institutions that remain relevant under FASB ASC Topic 326.

According to a Supervisory Letter from the Fed, the interagency policy statement is relevant for an institution when the institution adopts FASB ASC Topic 326. For institutions that have adopted the accounting standard, the interagency policy statement replaces the guidance presented in two policy statements on the allowance for loan and lease losses: SR letter 06-17, "Interagency Policy Statement on the Allowance for Loan and Lease Losses (ALLL)" SR letter 01-17, "Final Interagency Policy Statement on Allowance for Loan and Lease Losses (ALLL) Methodologies and Documentation for Banks and Savings Institutions." The Fed’s letter stated that an institution should continue to refer to SR letter 06-17 and SR letter 01-17 for relevant guidance until its adoption of FASB ASC Topic 326.

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