1. ©2014 CliftonLarsonAllen LLP CLAconnect.com Preparing for CECL: the Current Expected Credit Loss Model August 29, 2016 Presentation for the National Association of State Credit Union Supervisors

2. ©2014 CliftonLarsonAllen LLP Chuck Kelly Senior Manager with CliftonLarsonAllen LLP (CLA) Over 14 years of experience, working primarily with credit unions and other financial institutions Recent presentation and articles: –Presentation: “TDR’s... And the Saga Continues” –Presentation: “GAAP Update and Upcoming FASB Guidance to Keep on Your Radar...” –Presentation: “Understanding CECL and Current Trends” –Article: “New Guidance May Simplify Goodwill Accounting for Credit Union Mergers” –Article: “Impact of New FASB Financial Instruments Guidance on Credit Unions” Master of Accountancy, Virginia Tech Member of: –AICPA –Maryland Association of CPAs Today’s presenters 2

3. ©2014 CliftonLarsonAllen LLP Brittany Stern Manager with CliftonLarsonAllen LLP (CLA) Over 6 years of experience, working primarily with credit unions and other financial institutions Master of Accounting and Business Advisory Services, Towson University Member of: –AICPA –Maryland Association of CPAs Today’s presenters 3

4. ©2014 CliftonLarsonAllen LLP Current Expected Credit Loss Model  ASU 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” issued during June of 2016.  Today’s Agenda:  Why CECL?  CECL vs. Incurred Loss Model  Terminology  Disclosures  Available-for-Sale Debt Securities  Recommendations during the Implementation Phase  Questions? 4

5. ©2014 CliftonLarsonAllen LLP CLAconnect.com Why CECL?

6. ©2014 CliftonLarsonAllen LLP Purpose of CECL  FASB wished to address weaknesses identified in current practice following the recent global economic crisis by: Removing the “Probability Threshold” Eliminating the complexity of multiple credit impairment models / balance sheet goals  But why is this important?  How is this expected to improve the reasonableness and/or reactiveness of our reserve estimates? 6

7. ©2014 CliftonLarsonAllen LLP 7 Banking Crises Financial Crisis Slide Source: July 21, 2016 FASB Webinar Loan $ increased 70% LLR $ decreased 8% Loan $ increased 44% LLR $ decreased 10% Banking LLR’s

8. ©2014 CliftonLarsonAllen LLP 8 Credit Union LLR’s Financial Crisis Loan $ increased 98.85% LLR $ increased 26.00% Loan $ increased 23.86% LLR $ increased 1,327.53%

9. ©2014 CliftonLarsonAllen LLP Purpose of CECL  “CECL” – Current Expected Credit Loss model Forward looking requirements Removes “Probable Loss” threshold Longer loss horizon Need for loan-level data  Overall Goal: Quicker recognition of losses.  Changes in the ALLL reserve balances under CECL will primarily reflect changes in credit quality, and flow through the Credit Union’s earnings. The hope is to improve transparency for financial statement users. 9

10. ©2014 CliftonLarsonAllen LLP Purpose of CECL Basic CECL Equation: Amortized Cost of the Asset – Allowance = The Amount Expected to be Collected Where Amortized Cost represents the unpaid principal balance adjusted for deferred fees and costs, prepayments, charge offs and nonaccrual practices 10

11. ©2014 CliftonLarsonAllen LLP Purpose of CECL  So what has changed based on this ASU?  Loans  Held-for-Investment – CECL  Held-for-Sale – Lower of amortized cost basis or market  Debt Securities  Held-to-Maturity – CECL  Available-for-Sale – Credit Losses will be recorded through an allowance (difference between amortized cost basis and fair value)  Trading – Fair Value (no change from current GAAP)  Purchased Assets with Credit Deterioration  Similar to current GAAP, but initial allowance added to purchase price rather than as provision expense 11

12. ©2014 CliftonLarsonAllen LLP CLAconnect.com CECL Model vs. Incurred Loss Model

13. ©2014 CliftonLarsonAllen LLP Incurred Loss ALLL (Current Model)  The incurred loss model currently used to estimate the Allowance for Loan Losses utilizes several different components including: Homogeneous loan pool reserves Non-homogeneous specific loan reserves Reserves for qualitative and environmental (Q&E) factors 13

14. ©2014 CliftonLarsonAllen LLP Incurred Loss ALLL (Current Model)  The existing method generally: Delays recognition of credit losses until the loss is “probable” Considers losses that will most likely be reflected as charge-offs during the next operating cycle In practice, what is deemed to be an operating cycle may vary significantly 14

15. ©2014 CliftonLarsonAllen LLP CECL vs. Incurred Loss  Life of loan losses vs. losses over the next operating cycle for collectively evaluated assets  Based on current, known factors and reasonable and supportable forecasts about the future  Concept – Every new loan originated increases exposure to credit risk  Contractual loan payments of principal and interest reduce this exposure 15

16. ©2014 CliftonLarsonAllen LLP 16 CECL vs. Incurred Loss

17. ©2014 CliftonLarsonAllen LLP Data Inputs Current Expected Credit Loss model will be based on information such as: Past events Historical loss experience Current conditions Borrower credit worthiness -and- Forecasts of expected credit losses Current point and forecast direction of economic cycle 17 Hmmm, not a fan of the last two

18. ©2014 CliftonLarsonAllen LLP Data Inputs FASB expects that a credit union’s estimate of expected credit losses will largely be informed by historical loss information for financial assets of a similar type and credit risk. The expected credit loss estimate represents a life of loan estimate and considers: Prepayments Collateral value Current and expected economic conditions (compared to loss history) 18

19. ©2014 CliftonLarsonAllen LLP Vintage Year Concept 19

20. ©2014 CliftonLarsonAllen LLP Vintage Year Model Example Assumptions –$1 million in new loan originations per year –5 year principal payback –5 year life of loans –No prepayments –1% life of loan losses expected for each vintage –Predictable loss curve 20

21. ©2014 CliftonLarsonAllen LLP Vintage Year Model Example For this example, we begin with loans originated in 2012, since we are estimating our reserves in 2016, and 2012 is the last vintage that will have collections in 2016: 21

22. ©2014 CliftonLarsonAllen LLP Vintage Year Model Example Next, we will invert our historical and expected collections from the last slide to take a look at our historical and expected charge-offs: 22

23. ©2014 CliftonLarsonAllen LLP Vintage Year Model Example The ALLL equals the expected losses, less losses recognized to date. The ALLL stabilizes at 0.8% in 2015. Notice, there are no additional reserves for impaired loans! 23

24. ©2014 CliftonLarsonAllen LLP Economic Cycle Concept 24

25. ©2014 CliftonLarsonAllen LLP Practical Expedient for CECL Modeling What should you do if you lack support to reasonably estimate losses over the entire remaining life of your loan portfolio? A practical expedient is available Revert back to historical loss information Adjust for economic cycle expectations. 25

26. ©2014 CliftonLarsonAllen LLP Effective Date For Non-PBE’s (including credit unions) for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 31, 2021. Early adoption is available for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. 26

27. ©2014 CliftonLarsonAllen LLP CLAconnect.com Terminology

28. ©2014 CliftonLarsonAllen LLP Collateral Dependence  A practical expedient is available for collateral dependent financial assets  A collateral dependent asset is a financial asset for which repayment is expected primarily or substantially through: Operation of the collateral Sale of the collateral 28

29. ©2014 CliftonLarsonAllen LLP Collateral Dependence A Collateral dependent reserve estimate depends on reason for collateral dependence: Operation by lender –Compare the amortized cost to the discounted fair value of the collateral Sale of collateral –Compare the amortized cost to the discounted fair value of the collateral, less expected selling costs NOTE: This practical expedient should not be applied to loans that do not meet the definition for collateral dependency 29

30. ©2014 CliftonLarsonAllen LLP Troubled Debt Restructurings (TDR’s) They Still Exist… The accounting guidance for TDR’s remains largely unchanged, with the following tweaks: No requirement to estimate reserves on TDR’s using a discounted cash flow (DCF) analysis, other measurement approaches may be used. Subsequent modifications can remove TDR status if the terms of the new loan do not represent a TDR. 30

31. ©2014 CliftonLarsonAllen LLP Purchased Financial Assets with Credit Deterioration (PCD) ASC 310-30 – Loans and Debt Securities Acquired with Deteriorated Credit Quality Calculation Includes –Contractually Required Payments –Cash Flows Expected to be Collected –Nonaccretable Difference –Initial Investment –Accretable Yield All of which are tracked separately 31

32. ©2014 CliftonLarsonAllen LLP CECL Accounting for PCD CHANGE – Items are no longer tracked separately but the allowance is included with the CECL allowance Credit Union’s should estimate and record an allowance for credit losses at the time of purchase, which is then added to the purchase price rather than being reported as a credit loss expense The remaining difference between the purchase price, plus the allowance, and the contractual cash flows is a non credit discount 32

33. ©2014 CliftonLarsonAllen LLP Factors to Consider when Estimating Credit Losses on PCD The borrowers financial condition, credit rating, credit score, asset quality or business prospects The borrower’s ability to make scheduled interest or principal payments The remaining payment terms of the financial asset The remaining time to maturity and the timing and extent of prepayments The nature and volume of the entity’s financial assets The volume and severity of past due financial assets and adversely classified or rated financial assets The value of the underlying collateral of the financial assets Entity’s lending policies and procedures 33

34. ©2014 CliftonLarsonAllen LLP CECL Accounting for PCD 34 Non Credit Discount (Accretable ) Allowance Purchase Price Contractual Cash Flows Amortized Cost Basis Example: A Credit Union purchases a pool of loans with an unpaid principal balance of $1,000,000 for $750,000. Based on the Credit Union’s experience with the selling institution and previous losses on these types of loans, the expected loss is 15%. $100,000 $150,000 $750,000

35. ©2014 CliftonLarsonAllen LLP CLAconnect.com Disclosures 35

36. ©2014 CliftonLarsonAllen LLP CECL Disclosures Disclosure goals for user understanding: Credit risk inherent in the portfolio Credit quality indicators for all classes Except LOC’s and credit cards Disaggregated by vintage year for 5 years How management monitors credit quality Estimate of expected credit losses Changes in the estimate that have taken place during the current period 36

37. ©2014 CliftonLarsonAllen LLP CECL Disclosures – Non PBE’s 37

38. ©2014 CliftonLarsonAllen LLP CLAconnect.com Available-for-Sale Debt Securities 38

39. ©2014 CliftonLarsonAllen LLP Current Accounting All unrealized gains and losses on available-for-sale securities are recorded through Other Comprehensive Income CECL Accounting Two types of unrealized losses –Decline due to Credit Losses ◊ Recorded through an allowance –Decline due to Other Factors (Interest Rate Risk, Market Risk, Currency Risk, or Other Price Risk) ◊ Recorded through OCI Current vs. Future 39

40. ©2014 CliftonLarsonAllen LLP Credit Loss Considerations Extent to which the fair value is less than the amortized cost basis Adverse conditions specifically related to the security, an industry or geographic area Payment structure of the debt security Failure of the issuer of the security to make scheduled interest or principal payments Changes to the rating of a security by a rating agency Do NOT Consider The length of time a security has been in a loss position. –By itself OR in combination with others 40 Differentiating between Credit Losses and Other Factors

41. ©2014 CliftonLarsonAllen LLP CLAconnect.com Recommendations during the Implementation Phase

42. ©2014 CliftonLarsonAllen LLP Effect of Initial CECL adoption Credit unions will adopt CECL by posting a cumulative- effect adjustment to their statement of financial condition (undivided earnings) as of the beginning of the first reporting period in which the guidance is effective. Suggestion: Estimate the impact of this adjustment well ahead of effective date for capital planning purposes. 42

43. ©2014 CliftonLarsonAllen LLP Forming an Implementation Committee Forming a Committee –Look at how the ALLL estimate flows through the credit union, and how many business areas touch it –Strive for senior level representation Define Roles of the Committee –Set objectives and timelines –Determine responsibilities and scope out resource requirements –Provide regular updates to senior management and the Board Create a Project Plan –Regularly update your plan –Meet regularly, as defined by the plan 43

44. ©2014 CliftonLarsonAllen LLP Defining Roles for the Committee 44 –CECL will require collaboration across functional areas and a variety of disciplines –Committee members must understand their roles during the design and implementation of CECL –Assumptions used for the ALLL under CECL will need to be consistent across other functions and models (ALM & Stress testing) –An active committee will create a system of checks and balances Ideally, CECL should be viewed as an opportunity to improve the ALLL process Additional Considerations

45. ©2014 CliftonLarsonAllen LLP Factors for the Committee to Consider Methodology Changes 45 Data Requirements Capital Adjustment Communication Projected Impact There will not be one “right way” to accomplish CECL, but we would expect most credit unions will need to alter their current ALLL estimate methodology Historical Losses Migration Analysis Probability of Default / Loss Given Default Vintage Analysis Defining economic cycles Reasonable and supportable forecast Model validation Internal controls External provider?

46. ©2014 CliftonLarsonAllen LLP Factors for the Committee to Consider Methodology Changes 46 Data Requirements Capital Adjustment Communication Projected Impact Build and maintain a data warehouse Assessing availability and quality of historical data Determining key data necessary for the methodology you select Data validation process Report building process Gather industry data Gather economic data

47. ©2014 CliftonLarsonAllen LLP Factors for the Committee to Consider Methodology Changes 47 Data Requirements Capital Adjustment Communication Projected Impact Need to increase current capital? Timing considerations Management and Board Education Regulatory communications

48. ©2014 CliftonLarsonAllen LLP Factors for the Committee to Consider Methodology Changes 48 Data Requirements Capital Adjustment Communication Projected Impact Training and education of CECL with the Board and Senior Management Document new policies and procedures Periodic meetings Documents read into the Board minutes

49. ©2014 CliftonLarsonAllen LLP Factors for the Committee to Consider Methodology Changes 49 Data Requirements Capital Adjustment Communication Projected Impact Run scenarios to test initial model(s) Perform during the years leading up to the effective date for CECL Refine model(s) based on results Net income projections due to changes in provision Peer comparisons will change ALM impact Stress testing Loan pricing Underwriting guidelines

50. ©2014 CliftonLarsonAllen LLP Data Components by Methodology 50 Historical Losses Migration Analysis Vintage Analysis Individual loan risk classifications Migration between classifications Individual loan origination dates Individual loan origination amounts Individual loan charge- offs Individual loan recoveries Individual loan balances Individual loan pool segmentation Individual loan duration

51. ©2014 CliftonLarsonAllen LLP In the Meantime….. Challenges Regulatory and auditor unknowns –Reasonable and supportable forecasts –Economic cycle –Granularity of Loan Pools Life of loan estimates –Expected increase to your ALLL? –Potential underwriting implications? 51

52. ©2014 CliftonLarsonAllen LLP In the Meantime… Learn about acceptable methods –Historical loss rates –Migration –Regression –Vintage Year –Probability of default times loss severity –Risk rating categories (static pool analysis) Determine data availability Determine quantity of data Can use different methods for different loan types Investigate sources of industry data 52

53. ©2014 CliftonLarsonAllen LLP CLAconnect.com Questions?

54. ©2014 CliftonLarsonAllen LLP 54 ©2014 CliftonLarsonAllen LLP CLAconnect.com twitter.com/ CLAconnect facebook.com/ cliftonlarsonallen linkedin.com/company/ cliftonlarsonallen Chuck Kelly, CPA Senior Manager Baltimore, Maryland Direct 410-308-8076 Cell 410-908-5078 Chuck.Kelly@claconnect.com Brittany Stern, CPA Manager Baltimore, Maryland Direct 410-308-8153 Cell 443-880-2236 Brittany.Stern@claconnect.com Chuck Kelly, CPA Senior Manager Baltimore, Maryland Direct 410-308-8076 Cell 410-908-5078 Chuck.Kelly@claconnect.com Brittany Stern, CPA Manager Baltimore, Maryland Direct 410-308-8153 Cell 443-880-2236 Brittany.Stern@claconnect.com