NEW YORK–Credit unions seeking to grow need to recognize the effect of CECL extends far beyond the accounting function to a much longer-term issues, including forecasting, business models, strategic decisions, KPIs and especially the ability to communicate with non-financial people, according to one person.
“There is a side of CECL many are overlooking,” said Sally Myers, principal with c. myers corporation. “CECL requires a mindset shift. Initially, it is counterintuitive. Perhaps not to you, but certainly to other C-Suite executives and board members. There will be a disconnect between your actual financial performance and what you are showing on your financials. And that needs to be connected for non-financial people.”
Above all, said Myers in remarks to the CUNA Financial Council annual meeting here, credit unions must begin thinking longer-term under CECL in order to see the benefits of the analysis.
Myers, who was joined by Rob Johnson, EVP and principal with c.myers corporation, outlined a number of strategic considerations she strongly urged credit unions to consider in order to not just make good decisions but avoid making bad decisions once FASB’s CECL standard goes into effect.
The Big Impact
“The big impact is the initial adjustment,” said Myers. Among the adjustments CUs must prepare for, she said:
- Financial statements and ultimate financial performance could be disconnected
- Impact to financials
- Policy implications: CECL can be volatile
“Financial statements need to be thought about and viewed differently, and financial modeling will need to change,” Myers said. “It’s likely you are going to have to go out four or five years to really communicate the impact of the work you are doing. That’s going to be a big shift for many of you.”
To prepare for a more volatile environment, Myers urged credit unions to begin now.
“Begin practicing as if CECL were in place, and start experimenting with different policy limitations,” said Myers. “What you don’t want to do is have your policy box you in because of CECL’s volatility, especially around ROA and net worth.”
Scenario Offers Insights
As an example, Johnson reviewed three different hypothetical loans, Examples X, Y and Z. yields. Those loans yielded 2.25%, 4.50% and 5.50%, respectively, and had ECL of 0.25%, 1.50% and 2.50% respectively. Assuming a January to December fiscal yield on each, under CECL, in year one X would yield 1.64%, Y would yield 0.85% and Z would yield -0.58% (assuming loans made evenly over the fiscal year).
Under that scenario, does it mean not doing any of the Z loans? No, said Johnson, as that’s a year-one number. Over the lifetime of the loans, the net yields, respectively, would be 2.11%, 3.7% and 4.18%.
In the example shared, Myers stressed “timing matters.” Looking to a hypothetical $10 million in auto loans put on the books in January, the net yield in the sample scenario in year-one is 2.57%, with first year earnings of $199. In year two, it’s 4.50%, and over the life of the loans it’s 3.70%. The 3.70% number, she said, is “easier to get your minds around.”
The October Difference
But loans put on later in the year, for instance in October, changes the results. Using the same scenario, in year one loans made in October show a net yield of -4.65% and -$76 in income on the loan.
“You have to be able to explain that to people who aren’t living in the CECL world. CECL is forcing you to fast-forward the expected credit losses over the life of the loan,” said Myers. “So, in October, you haven’t had a chance to earn the revenue associated with those loans, because you only have a few months left in the year. Timing matters, but more importantly, communication matters, because you have the same net yield (3.70%) over the life of the loan.”
Is there opportunity in seeing the bigger picture when it comes to CECL? Yes, said Myers, especially if competitors don’t think through the life of the loan and remain in year one or have KPIs tied to incentives that might alter the timing of their loan promotions.
“For example, they might avoid any marketing in October due to negative effects on bonuses. It could create opportunity for people who are thinking longer term,” said Myers.
Potential CECL Impact on Financials
CECL will impact a credit union’s earnings and how much net worth it will need to handle fluctuations, said Johnson. In one of the counterintuitive aspects of CECL, Johnson noted there will be no impact under the new rules to any loan portfolio that isn’t growing or there is no change to the loan mix. But no credit union is seeking to shrink lending if it plans to remain a sustainable business, Johnson observed.
In the case of the overwhelming majority of credit unions which are forecasting growing loans, Johnson reminded CECL will have an effect on net worth that must be factored in.
Impact to KPIs
“I can’t say this enough: Start experimenting with KPIs now,” said Myers. “Again, this is counterintuitive. Growth has an impact on ROA. If loans shrink, it actually produces the highest earnings in year one. Loans growing actually decrease ROA. It doesn’t make sense, does it? No. But why is that happening?” asked Myers. “As you are growing the loans, you have to feed the CECL beast; you have to front-load the expected credit losses over the life of the loan. So, this has to be explained to other people making strategic decisions. How far out do you have to go in order to communicate with other decision-makers?”
It’s in years four and five of financial forecasting where the payoff on the effort can be found, according to Myers.
“If you only remember only one thing from today, remember that financial forecasting has to be longer term under CECL in order to see the benefits of your work,” advised Myers. “If you stop too soon, you probably are not going to make very good business decisions.”
Johnson told finance execs it’s imperative to look out to the fourth year on a loan, for instance, to see the cumulative earnings that result from a strategy of consistent growth, and then to the fifth year to see how the numbers are dramatically better. He suggested using a graphic or picture to tell the story to non-finance professionals.
The Problem With Experience
Myers suggested those most at risk of not fully understanding the effect of CECL across the organization are those executives who are long-time veterans of the credit union or financial services.
“There is something very serious that needs to be considered today,” said Myers. “You have been measuring success the same way for as long as you’ve been in business. So, start to consider how you are going to measure your business differently going forward. That’s a tough one.”
Enterprise Wide Imperative
Myers stressed again that CECL is not limited to the CFO or the Finance/Accounting Department.
“Your business is really pretty complicated. You have to start thinking about things sooner so you can get things done in a timely fashion and arrive when you want to arrive,” she said. “You only have five levers you can pull to get your financial results. So, if you’re in the CECL world and you’re accustomed to 1% ROA, you will need to pull other levers to make sure to get that 1% ROA. Remember, loan growth puts pressure in the shorter-term on ROA. On the other hand, if you say we think our strategy and business model are pretty solid and will help us going forward, you might need to change our mindset around shorter-term earnings so you don’t pull other levers too hard as a result of CECL. CECL can impact how you pull those other levers; make sure it’s a conscious decision. It’s going to be counterintuitive for a while. It’s about more than just checking the CECL box.”
Four Things to Remember
Myers reminded credit unions need to remember four things about CECL:
- CECL is not just an accounting standard change. It has the potential to change business models. “Whether it’s an opportunity or a disservice is up to you,” said Myers.
- Current and near-term KPS may not indicate the strength of your performance.
- Long-term forecasting needs to become a way of life.
- A deeper understanding of a CU’s data can help it see the profitability profile under different environments. “This understanding can uncover opportunities, such as better pricing or becoming more efficient,” Myers said.