CECL Blog Series – Part #4

This blog was authored by my colleagues, Dan Bauer, a principal in our financial institutions practice in Minneapolis, Minnesota

Welcome back to the CLA CECL Blog Series. As a reminder, over the next several weeks, CLA will take a deep dive into many of the hot topics surrounding the Current Expected Credit Loss (CECL) standard. In this blog, we’ll discuss the basics of qualitative factors and forecasting. Don’t forget – on October 28, 2021, CLA will host a webinar designed to answer any remaining questions you may have. You can sign up here. Make sure you receive our invitations by signing up for CLA communications here. We hope you find great value in this blog series and welcome the interaction with any of the authors.

Reserves for Unfunded Commitments under CECL

There has always been a requirement under GAAP to consider reserves for unfunded commitments and, if necessary, record a reserve independent of the allowance for loan losses for this exposure. However, many financial institutions have historically determined the amounts to be immaterial or have booked a nominal reserve amount that is infrequently reviewed for adequacy. With the change in orientation of loss reserves from an incurred loss model to a lifetime exposure model under CECL, this may no longer be the case.

Simplistically, the CECL reserve for unfunded commitments is a straightforward computation. Unfunded commitments, times the likelihood of funding, times the related loss factor for the category of commitments will equal the reserve. Conder the following hypothetical example:

• Unfunded line of credit commitments of $10,000 based on unused credit limit.
• A 10% probability that the unfunded commitment will become funded at any point in the future based on historical use patterns
• A 10% loss factor for line of credit liabilities developed under the CECL methodology utilized

Using the above assumed facts, the computed unfunded loss reserves would be $100 ($10,000 X 10% X 10%). This reserve is likely to be higher than a computed reserve under the incurred loss model and therefore may exceed management’s (and the auditors’) materiality threshold. The reserve for unfunded commitments would be recorded as a liability of the financial institution.

The computed level of unfunded commitments should not change as a result of implementing CECL so that part should be easy. Likewise, the loss factor should be “easy” to determine as this is the amount that is used in the allowance computation under CECL for the related funded commitments. There may need to be some qualitative adjustments based on the relative risk factors on the unfunded commitment versus the actual outstanding line of credit balances but overall, those should not be significant. The real key to this computation is determining the likelihood of funding. This will include an analysis of prior funding patterns, the nature of commitment (time limited verses open ended), and the nature of forecasts inherent in the overall CECL assessment. Will the likelihood of funding increase over historical patterns based on management’s forecasts of future economic activity or perhaps decrease? When are these commitments subject to renewal? What default level of likelihood of funding is appropriate? Answers to these questions could have a significant impact on the computed reserves and therefore management’s judgments related to these items will need to be documented, supportable, and consistent with critical assumptions used in the overall CECL reserve.

One item to consider that may have a significant impact on the overall reserves is whether the unfunded commitments are subject to unilateral unconditional cancellation (by the financial institution). To the extent that the financial institution can support this assertion (this is a legal determination), there would be no requirement for a reserve. Unconditional cancellation is different than the ability to adjust credit limits based on changes in FICO Score, underwriting guidelines, etc. Therefore, it will be critical to assess legal, contractual language if you believe that this exception to the general rule will apply to things like unfunded credit card limits.

As unfunded commitments become funded, the reserve for unfunded commitments will be reduced as the reserves for funded commitments (i.e., loans) will now be picked up in the CECL allowance.

Another example that this process will also apply is construction loans where an overall commitment is established, and periodic draws are expected to occur over a period of time.

How can we help?

Regardless of where your institution is at on your CECL journey, CLA is prepared to assist your institution in any way we can. Throughout this blog series or at any time, contact us with your questions. We look forward to being a resource for your institution as you navigate the implementation process!