As part of its proposed new standard on financial instruments, the Financial Accounting Standards Board (FASB) is proposing a new approach for recording credit impairment. This approach is being pursued by both FASB and the International Accounting Standards Board (IASB) as a result of the overall discussion by both boards to determine how to assess impairment. The ultimate goal is to develop a single model for measuring impairment for all financial assets.
The current standard requires banks to fund their allowance in accordance with Accounting Standards Codification (ASC) 450, formerly Financial Accounting Standard (FAS) 5 and ASC 310, formerly FAS 114. Under the current approach, a fundamental criticism is that the current incurred loss model results in a delayed recognition of losses and “too little, too late” in recording reserves.
In the new approach, FASB proposes a relative credit risk model incorporating forward-looking information under expected losses. The overall guiding principle of this model is to reflect the general pattern of loan credit quality deterioration. This new approach is based on expected credit losses and intended to be more responsive to changes in information affecting credit expectations. This relative credit risk model uses the concept of three buckets for measuring credit impairment:
- Bucket 1 – This is the starting point for all originated and purchased loans. Loans in this bucket would be good loans with good underwriting. However, within these loans are credit losses that are not yet identifiable. A bank would look at expected credit losses for a defined period of time (FASB is currently deliberating whether that period should be 12 or 24 months) and establish a reserve equal to those expected losses for Bucket 1 loans. FASB is committed to an operationally simple model for loans in this bucket. Reserves would be based on pools of loans.
- Bucket 2 – This bucket contains loans affected by occurrence of events indicating possible default, but specific identification of the loans affected has not occurred. For example, a decline in housing prices could indicate a pool of loans aligned with housing prices may be experiencing some impairment. As these events are identified, the pool of loans associated with those events would move from Bucket 1 to Bucket 2. Reserves would be based on the expected lifetime losses for the pool of loans identified.
- Bucket 3 – These are loans for which information is available that specifically identifies that credit losses have occurred or are expected to occur. These loans would be similar to the current model of FAS 114 loans, and reserves would be based on a specific evaluation of each loan in this bucket.
FASB clearly understands one of the significant challenges with this approach is the ability to distinguish those events significant enough to move loans between Buckets 1, 2 and 3. As a result, FASB staff is currently working on guidance and has formed working groups to visit with many different parties to provide this guidance.
One approach might be to align a bank’s internal loan grading system with the above buckets. For example, loans graded 1–3 might be considered Bucket 1 loans, loans graded 4–5 might be Bucket 2 loans and loans graded 6 or more would be Bucket 3 loans. Whatever the approach, the bank’s credit risk management system will be a key component in complying with this new proposed approach.
Before issuing the final document on financial instruments, FASB intends to expose the proposed amendments for public comments in the fourth quarter of 2011. Even when this new standard is issued, it is likely banks will have a few years to plan and adjust for these new changes. In the meantime, it is recommended to include as much information about each loan as possible within your loan accounting system. When it’s time to implement this new approach, you hopefully will already have most of the information within your loan accounting system.
For more on the proposed model, contact your BKD advisor.
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