Some banks are about to see how their loan books and allowance will fare under the new loss accounting standard.

Banks of all sizes are readying dry runs of their loan portfolios to gauge their performance under the current expected credit loss model, or CECL, which goes into effect in a little over a year. The exercise, commonly referred to as a parallel run, will show banks the gap in the allowance under the incurred approach and CECL. The parallel runs will also test banks' processes and controls around the allowance calculation and figure strongly into an institution's initial allowance disclosure.

Many banks are expected to increase allowances as they adopt CECL. A parallel run can help them to quantify the gap between the current allowance and expected one; figure out how it will impact capital levels and future earnings; and allow executives to make strategic decisions in underwriting, product mix and pricing to adjust for the new standard, said Brad Dahlman, senior product manager at allowance software company ProfitStars.

While the standard goes into effect in 2020, bank executives are running out of time to start these unofficial exercises if they want four quarters of data and practice.

"Most people work for 2020 adoption, but that's not really what you want to work for," said Jonathan Prejean, managing director at Deloitte & Touche who advises on accounting and reporting transformations. Banks should be working for the parallel run instead, he said.

Two books

A parallel run allows an institution to conduct a second set of operations that run alongside its current one, collecting real-time information about the allowance changes and other impacts. This is especially useful for banks that want to use a different methodology to calculate the allowance under CECL on certain portfolios to see if it produces a more accurate and potentially smaller number, said Garver Moore, managing director of advisory services at Sageworks, a banking software company.

Parallel runs are optional, which means it is up to banks to define their objectives and practices. Neither bank regulators nor the accounting board are involved in the parallel run process, although they could be interested in discussing banks' experiences and lessons.

Deloitte recommended a two-pronged approach of a dry run and a "dress rehearsal" in a white paper. A bank could spend the first half of 2019 running its CECL model with real internal loan and forecasting data that produces an adjusted allowance figure. Moore said bank executives should look at how quarterly volatility will impact the earnings statement and balance sheet, and consider how different loss accounting approaches can generate different results.

The parallel run should include testing the governance and controls around a bank's allowance process as well, Prejean said. The dress rehearsal would include more governance procedures, including approval from groups that sign off on the allowance, and it should also prepare executives to discuss the numbers and forecasts with investors. Management will want to pay attention to how many employees and resources and how much time it takes to run the parallel process.

In the parallel run, banks could involve their auditors, who could offer insight on the validation, processes, controls and documentation a bank will need as it attempts to model lifetime losses, Prejean said.

Two allowances

A number of large banks have disclosed their intentions to begin parallel runs sometime in 2019, including Regions Financial Corp., Sterling Bancorp, U.S. Bancorp, M&T Bank Corp., BB&T Corp., United Community Banks Inc. and Ally Financial Inc.

U.S. Bancorp is in the process of refining its models, said CEO Andrew Cecere during the bank's third-quarter earnings call. He said the bank would run in parallel during 2019 and is on track for adoption.

Some of ProfitStars' clients were already running a parallel process at the start of the fourth quarter of 2018, Dahlman said. Of those, a third were "dramatically under-reserved" and about two-thirds were "dramatically over-reserved," he said.

Some clients with portfolios of longer-duration loans such as mortgages have seen "surprisingly high" reserves, he said. But running the parallel has helped them understand the difference in allowance calculations so they can decide how to proceed once the standard becomes effective.

Executives can also begin preparing for the initial CECL allowance disclosures to investors ahead of the 2020 effective date, Moore said. Testing for the new allowance and preparing the explanation around it could make the final disclosure smoother.

"You could either be in a position [of] proactively ... communicating your approach, or you could be in a position where you pull the drape off of the painting and hope they like it," he said.

Click here to read more of our coverage on how banks are complying with CECL and IFRS 9. Click here to read S&P Global Market Intelligence's analysis of CECL's impact on the industry as part of our updated five-year outlook, and here to read about how CECL might have fared during the Great Recession.