What’s the Deal: How CECL Affects Broker-Dealers
What is CECL?
The Financial Accounting Standards Board (FASB) issued a new accounting standard in June 2016 that drastically changes the way companies record losses on loans, loan commitments, and other financial assets carried at amortized cost. The new current expected credit loss model, known as CECL, replaces the existing GAAP incurred loss model which requires a company to record an allowance when a loss is probable. Under CECL, companies must record on Day 1 an allowance for expected future losses over the lifetime of the asset and incorporate past events, current conditions, and reasonable and supportable forecasts.
How does this affect broker-dealers?
Many believe that CECL only affects commercial and retail banks with large loan portfolios. However, several transactions that are common within the broker-dealer industry fall within scope of the new standard, such as reverse repurchase agreements; securities lending agreements; underwriting receivables; and some securities segregated for regulatory purposes.
While the majority of a broker-dealer’s balance sheet is likely marked-to-market and therefore out of scope, many broker-dealers will still have material balances of in-scope financial assets. Therefore, if broker-dealers have not already started their CECL project, it is critical to commence scoping. This process requires the broker-dealer to identify asset classes that are subject to the new guidance and develop plans to address each class.
Fortunately, the new standard provides several practical expedients that broker-dealers can take advantage of to streamline the application of the new model. Broker-dealers should consider these as they work through the scoping process:
- Collateral maintenance provision: In situations where a borrower is required to continually adjust the amount of collateral securing a financial asset, an entity may compare the difference between the amortized cost basis and fair value of the collateral to record the loss. Broker-dealers should consider if their current contracts and collateral processes for reverse-repos will qualify for this expedient.
- Zero expected credit losses: This practical expedient can be used in cases where historical and current information, in conjunction with reasonable and supportable forecasts, conclude that expectation of non-payment is zero. Broker-dealers should consider if they have any segregated securities carried at cost that would qualify for this expedient (e.g., three-month US Treasuries that qualify as a cash equivalent)
- Collateral-dependent financial assets: If repayment is expected to be provided substantially by the collateral and the borrower is experiencing financial difficulty, an entity’s losses can be based on the fair value of the collateral. Broker-dealers should consider applying this expedient to securities-lending arrangements where the counterparty is experiencing financial difficulty.
After considering all available practical expedients, broker-dealers may find that certain types of assets will be within scope of CECL but not eligible for a practical expedient (e.g., underwriting receivables). If this is the case, broker-dealers will need to focus their efforts on measuring the expected credit loss, if material. Even if the new standard does not result in a material impact to the broker-dealer’s allowance, companies must still devote extensive time and resources to analyzing and documenting existing contracts and processes to satisfy management, auditors, and regulators.
In July 2019, following pushback from many in the banking industry, FASB voted to propose delaying implementation of CECL until January 1, 2023 for certain types of entities. The proposal would create two groups for determining the effective date of the new standard: The first is SEC filers (except for those qualifying as smaller reporting companies or SRCs) and the second is all other entities including SEC filers that qualify as an SRC. The first group will need to implement the standard by January 1, 2020 whereas the second group will not need to comply until January 1, 2023.
Many financial institutions will be able to take advantage of the deferral in effective date. However, because broker-dealers are generally required to furnish their financial statements to the SEC, most— with the exception of the smallest ones that qualify as SRCs—fall into the first group and must be ready by 2020. Broker-dealers should begin their CECL projects now, if they have not already, to be compliant before the beginning of the new year.