Transitioning Your Incurred Loss Methodology to CECL

Notes from the 2018 National CECL Conference session with Hans Pettit, Horne; Anthony Porter, Moss Adams; and Garry Rank, MST Regulators have urged institutions to leverage their current methodology for the allowance in transition to CECL but make changes to it, primarily in respect to life-of-loan and forecasting requirements. The FASB expects the transition to be scalable, but that “the inputs to the allowance estimation methods will need to change to properly implement CECL.” Compared to current GAAP, which requires you to reasonably estimate the amount of loss that has been incurred (upon meeting the probable requirement), CECL is more about what cash flows you expect not to collect at origination. And while current GAAP sees all loans as good until proven otherwise, under CECL, all loans are originated with some measureable risk of default. CECL requires loans to be pooled or segmented according to shared risk characteristics for measurement. Start that process by looking at how you are analyzing your risk segments now and how they will line up for CECL. Most institutions are using a call report structure on which to base their pooling. CECL will require a more granular approach than that, but you can start there as call codes contain much useful information. Your initial pooling decisions are likely to change as you move through the process, like your methodology choice and Q-factors. You will have to continue to ask yourself if your pooling structure remains appropriate given your risk profiling. Things that may bring about a change in pooling structure are new products, changes in underwriting and standards, and loan acquisitions. The way you look at risk under CECL is going to change. CECL will force you to peel the onion back to understand why a loan went bad and that will give you a clearer picture of your risk categories. Most banks haven’t been accumulating the data they’ll need for CECL, so by year four or five you will [...]

2018-11-30T10:57:59+00:00November 30th, 2018|ALLL, Blog, CECL|

ALLL / CECL Glossary

Banking with all of the various acronyms can be quite confusing, not to mention when you add in terms and acronyms from the FASB. To make it easier, we've developed this glossary of allowance and CECL terms. ALLL (Allowance for Loan and Lease Losses) – Originally referred to as the “reserve for bad debts,” a valuation reserve established and maintained by charges against a bank’s operating income. It is an estimate, calculated according to the incurred loss estimation model, of noncollectable amounts used to reduce the book value of loans and leases to the amount a bank can expect to collect. ACL (Allowance for Credit Losses) – Replaces the ALLL as a reference to the allowance under CECL. ACL is a more accurate term than ALLL under CECL, as CECL applies to a broader array of financial instruments than did the incurred loss model. Amortized Cost - The sum of the initial investment less cash collected less write-downs plus yield accreted to date. Amortized Cost Basis - The amortized cost basis is the amount at which a financing receivable or investment is originated or acquired, adjusted for applicable accrued interest, accretion, or amortization of premium, discount, and net deferred fees or costs, collection of cash, write-offs, foreign exchange, and fair value hedge accounting adjustments. ASU 2016-13 – The FASB update establishing a new accounting standard for estimating the allowance for credit losses (ACL). This ASU represents a significant change in the incurred loss accounting model by requiring immediate recognition of management’s estimates of current expected credit losses (CECL) throughout the lifetime of the loan. Back-Testing- A term used in modeling to refer to testing a predictive model on historical data. Systems that quantify risk ratings in terms of default probabilities or expected [...]

2018-11-20T12:34:36+00:00November 20th, 2018|Blog, CECL|

Don’t You Forget About Me: The Impact of CECL on Debt Securities

Notes from the 2018 National CECL Conference session with Gordon Dobner, BKD; John Griffin, BKD; and Dale Sheller, The Baker Group The impact of estimating credit losses for debt securities for most community financial institutions is relatively minor, certainly not as impactful as for loans. Guidance for estimating held-to maturity securities (HTM) follows the CECL standard like loans. There are fairly minor changes relative to assets-for-sale (AFS) debt securities, a modified version of today’s OTTI model. In addition for AFS and HTM securities, you’re buying after their original issuance, you have to consider whether they will fall into the PCD category. The biggest impact is determining the rigor with which you have to approach this. Typically you wouldn’t expect any losses, but the standard says to document. You don’t have to have a loss measurement if the expectation is zero at default – anything issued by the federal government that are backed, like U.S. treasuries, has a zero loss expectation. The expectation is that for most institutions the impact of CECL on HTM will be on municipals and corporate bonds. You could get to an expectation of zero if there is insurance or some other type of guarantee. You could also call it close to zero and immaterial, eliminating the need for a reserve. It is not as simple as just feeling you won’t have losses, you will have to document it. Municipal defaults over 30 years are at .15 percent, very rare, much more rare than corporate defaults, which could support your documentation of zero credit loss or immateriality. If you don’t believe zero is the answer, there will be pooling considerations, and a need to pull out securities where there might be a specific identified loss issue and analyze those [...]

2018-11-16T09:48:18+00:00November 16th, 2018|Blog, CECL|

Forecasting: Considerations for a Reasonable and Supportable CECL Forecast

Forecasting might not be top of mind as you prepare for CECL. Understanding the standard, deciding whether to handle the transition internally or engage third party assistance, gathering data, pooling, choosing a methodology – those issues drive our concerns well before we encounter a “reasonable and supportable” forecast. The forecasting piece is, in large part, what makes CECL different from incurred loss estimating. The Great Recession revealed the insufficiency of being able to reserve only for a probable or already incurred loss event; those years proved the incurred loss model “too little, too late.” The FASB determined we needed a forward-looking component to be prepared for an economic downturn when it comes – and not only a Great Recession, but a local economic jolt, like the closing of a factory that employs a significant portion of the local population. CECL allows us to do that, even to the extent of reacting to a rumor, be it from a credible source. Ultimately we are forecasting why the future is different from the past, be it better or worse. We do that using economic factors. External factors can be broad in scope, such as political turmoil or a trade war. Or they can be local, such as a weather event or the opening of a new business that will increase employment in your area. And they can reflect internal factors, like losing a quality loan officer to another institution, or signing new loan talent, or the closing of a competing institution. Here are a few things to consider when developing the forecasting piece of your CECL process: Initially, identify the variables that will determine expected losses. What specific factors apply to your population, your institution? Hone in on the most important factors; don’t complicate [...]

2018-11-05T13:17:42+00:00November 5th, 2018|Blog, CECL, Economic Forecasting|

What is the Vintage Methodology for CECL?

The Vintage Methodology under CECL (Current Expected Credit Loss) measures the expected loss calculation for future periods based on historical performance by the origination period of loans with similar life cycles and risk characteristics. It’s advantageous to pool similar loans that follow comparable loss curves that may be predictive for future periods. There are a handful of characteristics you should look at when segmenting your loans with the Vintage methodology. The most important risk driver is that all loans share a common origination period. Contrasted to the cohort method, loans are only included in tracking historical losses in the period in which they originated. Upon renewal of a loan, a new vintage is created. Critical data elements needed to run Vintage include loan number, balance at origination, loan balance, maturity date, renewal date, and loss information. The loans in the pools for this methodology should have similar risk characteristics and can be sub-segmented by an optional risk driver, like risk rating, although many times pools will become too granular to use this optional driver. Loan pools should  have very similar weighted average lives because loss rates in year two of a three-year loan looks vastly different than year two of a seven-year loan. Vintage works well with indirect auto loans and other consumer loans, credit portfolios, etc. To determine loss rates with this methodology, start with historical loss rates for each vintage and examine any trends in recent vintage loss rates. Fill in loss rates for future periods based upon historical trends as well as factoring in any changes for current conditions and reasonable and supportable forecast periods where you anticipate these periods are different from historical. Depending on differences in the makeup of the vintages, different adjustment factors may be required for each vintage. Depending on forecasted conditions, adjustments could be either positive or negative. When future years are no longer reasonably forecastable, revert to adjusted historical averages. Re-evaluate your Q factors with shifts in the economic landscape. When figuring out [...]

2018-10-26T13:07:18+00:00October 26th, 2018|Blog, CECL, Methodologies|

What is the PD/LGD Transition Matrix Model for CECL?

The transition matrix model (TMM) determines the probability of default (PD) of loans by tracking the historical movement of loans between loan states over a defined period of time – for example, from one year to the next – and establishes a probably of transition for those loan types between different loan states. […]

2018-10-24T11:14:12+00:00October 19th, 2018|CECL, Methodologies|

Florence Distorts Job Numbers; Labor Market Remains Strong

Guest blog by Dr. Tom Cunningham, Economist and MST Advisory Services, Senior Advisor- Economics The headline numbers from the Bureau of Labor Statistics’ (BLS) September jobs report suggest a mixed employment situation. New jobs came in at just 134,000, well below the expected 180,000, while that headline unemployment rate, U3, fell 0.2 percentage points to 3.7 percent, slightly lower than the 3.8 percent expected. […]

2018-10-23T17:31:16+00:00October 9th, 2018|CECL, Economic Forecasting, Economic Indicators|

Time – and CECL – Wait for No One

Use our industry experience to build your institution a CECL “backward timeline.”  From the very announcement of the CECL implementation dates, we have been working with lenders – and spilling a lot of ink – on timelines. When do you need to get started on your CECL transition to have enough time to be ready for your implementation date?  […]

2018-10-24T10:12:41+00:00October 5th, 2018|CECL|

Overcoming Organizational Obstacles in Transitioning to CECL

Who owns the present Allowance for Loan and Lease Losses (ALLL) and the new Allowance for Credit Losses (ACL) processes in your financial institution? The Chief Financial Officer (CFO)? The Chief Credit Officer (CCO)? The Chief Lending Officer (CLO)? Perhaps it is a shared function. In my 40 years in banking, I have seen the responsibility fall to each of these roles.  […]

2018-10-23T23:29:42+00:00September 28th, 2018|CECL|