FDIC and OCC Reach out to Auditors
As part of their ongoing efforts to increase the lines of communication between regulators and auditors, the FDIC and OCC each recently held meetings with auditors to discuss current accounting and supervisory topics of concern to the regulators. BNN representatives participated in each of these sessions.
Among the topics discussed were: the current ALL model and supervisory iCECssues, the definition of Public Business Entities, investment securities, subsequent restructuring of troubled debt, and of course, CECL. Following is a summary of matters raised by either or both of the regulatory bodies we think will be of particular interest to our clients.
Current Accounting for Loan Losses
Concern was raised that there has been a loosening of underwriting standards since the days of the last financial crisis as some banks may be chasing yields. In calculating the ALL, the regulators have seen instances of banks adjusting their “lookback” periods used in establishing the qualitative loss factors, without necessarily providing adequate documentation to justify the change. In establishing the lookback periods, the regulators are concerned that banks appropriately assess the loss emergence period (LEP) for the various types of loans. The LEP is the period of time from when the borrower experiences events that culminate in the borrower’s inability to repay the loan, including that period when performance continues so that the loss is not visible (otherwise known as the “blind period”), to the time the bank has sufficient information to confirm the loss and take a charge-off. Lookback periods shorter than the LEP do not capture the full incurred loss emergence cycle. Management should select a lookback period that is at least as long as the LEP, document the basis for the period selected and, when changes are required, clearly document the reasons for the change. Qualitative factors should impact the allowance the most and should be well thought-out, well documented, and translated into quantitative amounts. The regulators cautioned that it is not permissible to keep allowances artificially high to prepare for CECL.
Public Business Entities (PBE)
Mutual institutions and certain non-SEC registrant stock banks may be surprised to learn that they could possibly be deemed to be a Public Business Entity (PBE). Why is this important?
Most newly issued accounting standards contain differing implementation dates for entities that meet the definition of a PBE than the implementation dates for other reporting entities. Additionally many accounting standards either contain enhanced disclosure requirements for PBEs or prevent adoption by PBEs. For example ASU 2016-01 Recognition and Measurement of Financial Assets and Financial Liabilities, which among other components requires certain equity investments to be measured at fair value with changes reflected in net income, is effective for periods beginning after December 15, 2017 for PBEs, whereas for entities that do not meet the definition of a PBE, the effective date is for periods beginning after December 15, 2018.
The definition of a PBE is much broader than simply an entity that is required to file reports with the SEC. Some community banks may inadvertently or unknowingly meet the definition of a PBE. (See ASU 2013-12 Definition of a Public Business Entity.) One aspect of FASB’s definition of a PBE is that the entity “…has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including footnotes) and make them publicly available on a periodic basis…” (Criterion e.)
Banks that are subject to FDICIA must, by law, file audited financial statements with the regulators and make them publicly available upon request, so therefore meet one of the two criteria discussed above. Banks that have issued trust preferred securities (TPS) could likely meet the second criterion if the TPS are not restricted from transfer.
There are still many technical aspects of this definition that are being researched and discussed. Some interpretations currently suggest that banks which have issued brokered certificates of deposit would meet the definition of having issued a security not contractually restricted as to transfer. Generally brokered CDs are negotiable and investors can sell unwanted CDs through a broker. The FDIC has not taken a position on this issue, and is awaiting further guidance from FASB. We will update you as soon as there is any clarity on this matter.
Another criterion in the definition of a PBE is an entity that “…has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market” which includes an interdealer quotation or trading system for securities not listed on an exchange (for example, OTC Markets Group, Inc., including the OTC Pink Markets, or the OTC Bulletin Board.) (Criterion d.) The regulators are interpreting criterion d. broadly.
It is important that each financial institution document their status as either a public business entity or a private company.
Investments in Bonds
Among the many components of the Dodd Frank Act was the requirement that regulators remove references to ratings provided by rating agencies from regulations surrounding the definition of investment grade securities. As such, Banks can no longer rely solely on credit ratings to determine if a security is investment grade. Regulators require that institutions perform some form of credit analysis or pre-purchase analysis for certain investment securities such as corporate and municipal bonds. In practice, the credit rating by the rating agency can be a component of the pre-purchase or credit analysis. Pre-purchase analysis must be conducted on each bond in order to meet safety and soundness guidance and such analysis should incorporate credit risk, interest rate risk and liquidity risk. Additionally there should be ongoing monitoring of each bond which must be completed and documented at a minimum annually, or more frequently, depending on the risk characteristics of the investment. A bank may find it beneficial to grade a bond consistent with how it grades a commercial loan, by assessing and scoring various factors.
Accounting for Subsequent Restructuring of a Troubled Debt Restructuring (TDR)
When a loan has previously been modified in a TDR, the lending institution and the borrower may subsequently enter into another restructuring agreement. The facts and circumstances of each subsequent restructuring of a TDR loan should be carefully evaluated to determine the appropriate accounting under U.S. GAAP. Under certain circumstances it may be acceptable not to account for a subsequent restructured loan as a TDR. The federal financial institution regulatory agencies will not object to an institution no longer treating such a loan as a TDR if at the time of the subsequent restructuring the borrower is not experiencing financial difficulties and, under the terms of the subsequent restructuring agreement, no concession has been granted by the institution to the borrower. To meet these conditions for removing the TDR designation, the subsequent restructuring agreement must specify market terms, including a contractual interest rate not less than a market interest rate for new debt with similar credit risk characteristics and other terms no less favorable to the institution than those it would offer for such new debt. When assessing whether a concession has been granted by the institution, the agencies consider any principal forgiveness on a cumulative basis to be a continuing concession. This approach was discussed with and agreed to by the SEC.
The FDIC expressed their belief that all TDR loans should have an allowance for loan losses assigned to them. When evaluating the expected future cash flows on those TDR or impaired loans that are not deemed collateral dependent, expected future cash flows should incorporate the risk that payments may not be made based on the contractual terms of the loan. As a result, expected future cash flow projections will generally be less than contractual payments, resulting in an assigned allowance for loan losses.
Much has been written about CECL, so we will not repeat it here. A few takeaways from discussions with the OCC and FDIC include:
- The regulators reiterated that they do NOT believe community banks will need pricy models to adopt and apply CECL. There may be some changes to systems needed to capture additional data used in the analysis, and data may need to be maintained for a longer period.
- Any approach selected should be suitable for the institution’s portfolio and be supported.
- Banks will continue to use quantitative and qualitative factors, and the qualitative factors should again be heavily weighted.
- Representatives indicated the FDIC does not have any defined expectations related to each financial institution’s preparation for CECL. They intend to issue an FAQ on CECL in December 2016.
If you have any questions, please call your BNN advisor at 1.800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.