Community Banking Connections

Print Article

March 2025

CECL at Community Banks: Early Assessments of the Allowance for Credit Losses
by Robert Canova, Senior Examiner, Supervision and Regulation, Federal Reserve Bank of Atlanta, and Ross Crouch, Lead Examiner, Supervision and Regulation, Federal Reserve Bank of Kansas City

The issuance of the current expected credit losses accounting standard,¹ more commonly known as CECL, by the Financial Accounting Standards Board (FASB) changed the way that banks estimate credit losses² and has been a primary topic of conversation in the banking industry for nearly a decade. Banks anticipated challenges in adopting the new standard, including challenges related to the operational complexity of implementation. 

Now that the period for CECL adoption has passed, the focus for supervision has shifted from monitoring banks’ preparation for implementation to assessing banks’ allowance for credit losses (ACL) and the impact on banks’ safety and soundness. Because of the time frames between mandated exams, as well as tailored supervision, some banks have already had their first exams post CECL adoption while the first exams for other banks are still forthcoming. The results of these first exams have shown that banks generally made a good faith effort in adopting CECL; however, there are some lessons learned from these exams that may help refine banks’ allowance processes.

Good Faith Efforts

Examiners continue to evaluate whether a bank’s allowance methodology is consistent with U.S. accounting standards and assess whether the level of the bank’s ACL is appropriate given the bank’s risk exposure. Initial examinations for community banks after the adoption of CECL focused primarily on determining whether management made a good faith effort to effectively implement the new allowance methodology in accordance with the FASB standard. Recent community bank examinations that included an assessment of CECL implementation generally focused on both a bank’s governance and risk management, in addition to the overall adequacy of a bank’s ACL level.³

As part of assessing good faith efforts in the examination process, examiners determined whether the bank’s CECL methodology and related assumptions were reasonable, such as ensuring that all loan portfolios were included in the new methodology or that management developed reasonable economic forecasts consistent with a loan portfolio’s primary loss drivers. In addition, risk management practices were also assessed, such as whether management updated the allowance policy or developed adequate documentation of new CECL processes. Examples of potential examination issues include material departures from the FASB standard, such as not using economic forecasts or not developing qualitative adjustments reflective of the bank’s underwriting practices, and lack of proper governance over the ACL estimation process. An example of a bank not making a good faith effort is the bank not adopting the new standard at all.

In assessing good faith efforts to adopt the new standard, examiners tailored their expectations around both the asset size and business complexity of the bank, as well as any operational risks associated with implementing new processes.⁴ Smaller banks, usually those with less than $1 billion in assets, tend to offer a smaller array of products and services that are common to most banks within their local markets, which influences how they approach their CECL methodology. These banks tend to have a more limited risk appetite and operate using a traditional relationship banking model. Given their size and resources, they also have less of an ability to absorb regulatory costs, another influencing factor in their approach to CECL. As such, regulators do not have the same risk management expectations of these types of banks as they do for banks that are typically larger, operate across a wider geographical footprint, and offer a broader set of products and services with a higher risk profile. Risk management practices in larger community banks would need to reflect the increased complexity of their product offerings and diverse customer base.

Highlights of State Member Bank Examinations

From nearly 200 community state member bank (SMB) examinations across the Federal Reserve System conducted between May 2023 and May 2024, examiners determined that community banks generally made a good faith effort in adopting the new standard. Most banks were able to effectively operationalize CECL despite management concerns about its feasibility before the implementation date.

Even though most community banks made a good faith effort to implement the new standard, supervisory findings can still be issued as a result of an examination. Recommendations were identified both for community banks using models developed by third parties and for community banks using internally prepared calculations, such as the Scaled CECL Allowance for Losses Estimator (SCALE) tool developed by the Federal Reserve.⁵

Although the types of findings varied (see Figure), most of the supervisory concerns and recommendations thus far have centered around either a bank’s inadequate documentation of the ACL estimation process or unsupported qualitative factors (Q factors) used in determining the ACL estimate.

Inadequate Documentation

Examiners identified documentation issues such as nonexistent or outdated allowance policies, procedures, and controls that failed to align with the new CECL methodology. Specific methodology areas requiring a bank’s documented support include rationale for the selected calculation method(s), key assumptions specific to the calculation method(s), look-back period length, and segmentation. In some of the cases in which a community bank used a third-party model, bank management did not adequately document support for key assumptions, qualitative adjustments, and related policy guidance. Similarly, some community banks used internally developed calculations but did not effectively document their support for qualitative adjustments.

Q Factors

While the use of quantitative calculations should form the basis of a CECL estimation, the FASB standard directs banks to consider relevant and supportable Q factors in calculating an ACL. The Q factors should address the risk of loss that may not be captured within the quantitative calculation.⁶ Instances were noted of bank management placing too great a reliance on quantitative measures without the appropriate consideration or weight being placed on identified qualitative measures to address risks not captured by the quantitative calculation.

As an example, Q factors such as the current unemployment rate in a bank’s local market and other local economic metrics may help, among other things, incorporate risks missing from historical data to form a better basis for determining an appropriate ACL level. In addition, new banking activities are also a point of consideration when determining Q factors. Some examination findings required community banks to qualitatively adjust their ACL for risks not captured in their credit loss history, such as growth in new markets or significant new and inherently risky loan segments, like a new commercial real estate lending product. 

ACL for Held-to-Maturity Securities and Other Concerns

Other concerns identified during examinations include inadequate segmentation of a bank’s loan portfolio by similar risk characteristics and concerns about management’s calculations of expected credited losses on held-to-maturity (HTM) securities and off-balance sheet items. Under CECL, banks must create an allowance for any expected credit-related losses on HTM securities and recognize losses in the same manner as loans, which represents a departure from the other-than-temporary impairment method used before CECL. This is a new process for management, and examiners provided feedback on better implementing this change. These issues were more common for community banks using internally generated calculations like SCALE, as HTM securities and off-balance sheet items are not included in the SCALE tool. Bankers are reminded of the requirement to reserve for off-balance sheet items under CECL, as was previously required under the incurred loss methodology.

Determining the Adequacy of the ACL

Beyond assessing the governance associated with the new CECL methodology, examiners also determined whether the overall adequacy of the ACL supports the level of a bank’s credit risk. The examiner assessment of the adequacy of the ACL, which now covers expected losses over the life of the credit exposure, was typically informed by the types of credit exposures on balance sheets, the existence of any off-balance exposures, and the level of concentrations of any loan types. 

The adequacy of the allowance has been a longstanding theme in previous bank examinations. During examinations following CECL adoption, examiners cited some individual banks with findings related to inadequate ACL levels. Specifically, the practice of using outdated historical loss rates or an overreliance on legacy incurred loss calculations by some banks contributed to inadequate ACL levels.

Examiners also continue to identify ACL adequacy issues at community banks connected to broader credit risk management issues and less-than-satisfactory asset quality, which is not new under CECL.  Issues with ACL adequacy were primarily driven by credit risk not being captured by the credit loss calculation, which could have been driven by a number of factors, such as inadequate credit risk identification or inadequate loss estimates on loans assessed on an individual basis. Inadequate ACL levels were also driven, in some instances, by growth in a higher-risk loan segment or new lending markets that weren’t captured in the ACL calculation as well as by uncaptured higher-risk concentrations.

Additional Guidance

The federal bank regulators have issued guidance on policies and procedures for the systems, processes, and controls necessary to maintain an appropriate ACL, including Supervision and Regulation (SR) letter 16-12, “Interagency Guidance on the New Accounting Standard on Financial Instruments – Credit Losses,”⁷ and SR letter 19-8, “Frequently Asked Questions on the Current Expected Credit Losses Methodology (CECL).”⁸ SR letter 19-8 provides information on quantitative methods, qualitative methods, and reasonable and supportable forecasts, all of which are a part of the governance framework that is subject to examiners’ review.

Additionally, in 2020, the Federal Reserve issued SR letter 20-12, “Interagency Policy Statement on Allowances for Credit Losses,” to reflect changes in the allowance methodology as a result of implementing CECL.⁹ This letter updated supervisory expectations for governance and risk management practices that were previously outlined in SR letter 06-17, “Interagency Policy Statement on the Allowance for Loan and Lease Losses.” The Federal Reserve shared more information about CECL and general safety and soundness themes pertaining to bank examinations as part of the 2024 Accounting Roundtable, which was held on November 14, 2024, through the Ask the Fed webinar program.¹⁰

Conclusion

The historic transition from the incurred loss methodology to CECL represents one of the most significant changes to community banks’ allowance estimation processes in the last 30 years. Significant effort was made to implement CECL, with banks generally demonstrating a good faith effort in adopting CECL and initial examination recommendations being communicated on an advisory basis. As supervisors continue to assess the allowance methodology and allowance levels during examinations, community banks should review policies and procedures to promote alignment of their allowance process with the requirements of this “new” CECL methodology.

• ¹ See FASB Accounting Standards Update No. 2016-13, Financial Instruments—Credit Losses (Topic 326), available at https://bit.ly/41mkBTP.
• ² For more information, see Christopher Hahne, “New Rules on Accounting for Credit Losses Coming Soon,” Community Banking Connections, First Issue 2016, available at www.cbcfrs.org/articles/2016/i1/new-rules-on-accounting-for-credit-losses.
• ³ Examination activities and ACL levels were discussed during the 2023 Accounting Roundtable. A recording of the event is available at https://bsr.stlouisfed.org/askthefed/Home/ArchiveCall/355.
• ⁴ Expectations were outlined by the Federal Reserve in question 23 of the frequently asked questions about the new accounting standard, available at www.federalreserve.gov/supervisionreg/topics/faq-new-accounting-standards-on-financial-instruments-credit-losses.htm.
• ⁵ For more information about SCALE and qualitative factors, visit the CECL Resource Center, available at www.supervisionoutreach.org/cecl/scale.
• ⁶ See FASB Accounting Standards Update No. 2016-13, Financial Instruments—Credit Losses (Topic 326), Accounting Standards Codification 326-20-30-7.
• ⁷ SR Letter 16-12 is available at www.federalreserve.gov/supervisionreg/srletters/sr1612.htm.
• ⁸ SR letter 19-8 is available at www.federalreserve.gov/supervisionreg/srletters/sr1908.htm.
• ⁹ SR letter 20-12 is available at www.federalreserve.gov/supervisionreg/srletters/SR2012.htm.
• ¹⁰ See https://bsr.stlouisfed.org/askthefed/Home/ArchiveCall/376.