What is the Cohort Methodology for CECL?

Noting the diversity in portfolio sizes, complexities, as well as practices of applying the current incurred loss methodology, the FASB’s guidance on CECL offers quite a bit of latitude to financial institutions (FIs). It encourages FIs to leverage their current methods and existing systems in the application of a CECL compliant methodology. The general modeling strategies around CECL must incorporate the lifetime losses calculation, segmentation (one of the three pillars of CECL), determination and impact of adjustments, and the integration forecasts. Cohort Methodology A particular area of flexibility is with the determination of methodologies for the calculation of the allowance.  One of the main methodologies FIs are using is the Cohort methodology, which, as with all methodologies, requires institutions to make rational and defensible decisions. The Cohort methodology, or “snapshot” or “open-pool analysis,” relies on the creation of cohorts to capture loans that qualify for a particular segment, as of a point in time. They then track those loans over their remaining lives to determine their loss experience. Segmentation The most essential step in the utilization of the cohort-based methodology is the determination of the cohort – which starts with appropriate segmentation. The Update states that an “entity should aggregate financial assets on the basis of similar risk characteristics” when evaluating financial assets on a collective basis. Those characteristics include, but aren’t limited to, internal or external credit score, risk ratings, financial asset, loan type, collateral type, size, effective interest rate, term, or geographical location. Benefits that come with segmentation include a reasonable way for institutions to identify their key vulnerabilities and assess how to manage those risks. Segmentation enables the institution to capture the unique behavioral characteristics that vary the degree of inherent risk or increase the likelihood of loss. The [...]