Welcome back to Financial Literacy Month! While the primary reason for this month’s festivities, as explained in the earlier kickoff article, is to educate consumers on financial best practices, I have taken on the task of educating our community of credit union and CUSO employees on the insider knowledge we can benefit from.

For some of our readers, this is basic accounting or credit union information. But for individuals like myself, who entered the world of credit unions (now over 15 years ago) with no prior knowledge, much of credit union operations remained shrouded in mystery. And so it remains my goal to help shine a light on some of the acronyms (like ALM vs. AML) you might hear, the liquidity crises we see news about, and the ratios our leaders use to ensure the safety and soundness of our institutions. Or even something as basic as how to read a financial statement.

And so, as we dive into another year of our own financial education, I begin by taking a deeper look at some often herd, but maybe little understood terms: Allowance for Loan and Lease Losses and Current Expected Credit Losses.

Is that ALLL?

Starting with the basics, the Allowance for Loan and Lease Losses, or ALLL—more recently referred to as Allowances for Credit Losses (ACLs)—is an accounting standard that issues an account funded by the credit union meant to estimate the probable incurred losses on that credit union’s loan portfolio. In other words, it’s the credit union’s rainy day savings for possible defaulted loans.

The main purpose of the ALLL is to ensure that the credit union has adequate reserves in the event members default on their loans, thereby not jeopardizing the safety and soundness of the credit union. When a charge off on a loan is necessary, funds are debited from the ALLL and credited to the charged-off loan. Conversely, if some recovery is made, whether in full or partial, the ALLL is credited back.

No matter how conservative a credit union is with their lending practices, there will always be some risk that a member or business will not be able to make their payments. It is the responsibility of the credit union to understand these risks (loan concentration, geographic considerations, credit worthiness of borrowers, collateral, local economic conditions, etc.) and to establish an appropriate allowance for loan and lease losses to act as reserve.

More specifically, it is the credit union’s board of directors responsibility to directing management and approval of the institution’s ALLL methodology. In the 2023 Interagency Policy Statement on Allowances for Credit Losses—coauthored by the Department of the Treasury, Federal Reserve, FDIC, and NCUA—it was suggested that the board should review the policy annually.

But here’s where things get a little tricky.

The Financial Accounting Standards Board (FASB), an independent organization tasked with establishing accounting and reporting standards that follow Generally Accepted Accounting Principles (GAAP), created the Current Expected Credit Loss (CECL) standard in 2016, meant to replace ALLL.

FASB had argued that the prior methodology proved to have shortcoming during the 2008-09 financial crisis. Basically, that the existing methodology failed to recognize possible credit losses as the crisis loomed, causing financial institutions to inadequately fund their ALLL. Where ALLL accounts for losses expected over the next twelve months, CECL would seek to be more proactive in accounting for unexpected losses, looking at the entire life of a loan. On top of that, investors (not credit union owners, mind you), complained of a lack of transparency on the part of the lenders and their credit loss exposure.

Despite protestations from credit unions (and even some members of the NCUA board)—arguing that it was a response to the unsafe practices of banks and other for-profit lenders, not credit unions, during the financial crisis—CECL went into effect for most credit unions in 2023. Right off the bat, CECL calculations proved to be a chore, with NCUA stepping in to attempt to simplify the process.

Dissecting CECL

While I won’t get into the nitty-gritty of CECL and how credit unions are expected to calculate their expected losses, I can give some tidbits on the process.

When it comes down to it, the methodology for estimating expected credit losses is based on a combination of past events (internal and external historical loss data from similar assets), current conditions (borrower information, asset information, collateral value, current micro and macroeconomic factors), and “reasonable and supportable” forecasts that could affect collectability.

If you’re wondering just how far into the future credit unions are expected to forecast, the answer is vague.

According to the NCUA, “CECL does not prescribe a specific method for estimating R&S Forecast periods, and it does not include any specific guidance on a maximum or minimum length time. The standard makes it clear that management’s allowance estimates must be based on management’s expectations. For financial and regulatory reporting purposes, credit unions should support and document their R&S Forecast periods. Generally, a longer period will be less reliable and more difficult to justify as “reasonable.””

Mercifully, federally-insured credit unions under $10 million in total assets were exempted from CECL. Instead, they could continue to determine their Allowance for Loan and Lease Losses by using “any reasonable reserve methodology (incurred loss)”.

To assist those over $10 million in assets, NCUA assembled resources to assist credit unions with the implementation of CECL. However, its Simplified CECL Tool, which provides credit unions with a methodology for determining the ACL, was developed primarily for credit unions with less than $100 million in assets. As the tool relies on the Weighted Average Remaining Maturity (WARM) methodology, a FASB approved, but only for less complex asset pools, larger credit unions have had to do additional research.

Though this is only a fly-by look at ALLL and CECL, I hope it has given you the reader with a little more background on this highly important and confusing aspect of your credit unions’ operations.

As always, if there’s something you’d like to learn more about or if I have gotten some details wrong, please let me know in the comments below!