Regulators, auditors and industry professionals are all urging financial institutions (FIs) to begin now to prepare for the new current expected credit loss (CECL) standards, even though the effective date is over two years away. If you haven’t already, make 2017 the year your financial institution (FI) begins the planning and vendor selection process for your CECL modeling.
A successful transition to the CECL-based reserve methodology requires the active involvement of a CECL committee. Your committee should include representation from finance, loan underwriting, loan operations, IT, line personnel, and senior management. It’s also important to engage your audit committee and the board of directors. The audit committee is responsible for overseeing financial reporting, and your board of directors with your senior management representatives will be responsible for timelines and the costs associated with implementing a CECL solution.
Your committee needs to have broad representation, as the new requirement impacts many areas of your FI. Getting your cross-functional team in place now will help you identify any concerns and avoid problems down the road. Without engaging a broad team, you can make a bad decision about your CECL model requirements, which could expose you to regulator criticism and require changing models late in the process. Not having a broad set of team members can also result in poor internal communication and a lack of clarity of roles, which can elongate your timeline and risk non-compliance by your adoption date.
CECL is clear in the fact that changes are required to how credit risk is modeled and accounted for, but it also does not mandate any single model approach. There are many different modeling options available today and making a good decision for your FI is an important step in the process. The six most commonly described methods are:
Each FI should determine which methodology (or combination) is needed based on the size and balance sheet complexity. Selecting the wrong CECL model can expose you to regulatory scrutiny and cause you to start over in your CECL model selection process, which can be costly and time consuming.
After you have a good idea of the various paths to CECL compliance, the next step is reviewing CECL offerings to determine the best fit. With credit risk as the single largest exposure to your FI, effectively managing credit risk is essential. Finding and selecting a CECL model that can accurately assess your credit risk, is able to forecast changing economic conditions, and lets you see the impact on your reserves is essential. With ProfitStars' sophisticated Probability of Default (PD) model, we can help you assess the key driving factors in determining credit risk and reserve requirements.
As written, the CECL regulation often says "reasonable and supportable," and while this language is common for accountants and auditors, it doesn't provide much clarity for those evaluating CECL solutions. ProfitStars® believes that with this uncertainty, the best approach is to select a model with advanced capability to meet your needs and reduce the risk of regulators deeming your solution inadequate. Does your provider have:
Not all models are created equal, and a basic model could be deemed inadequate and put your organization at risk of regulator criticism.
By intention, CECL requirements allow time before adoption to locate, collect, and correct data. In fact, the FASB recommends significant historical data – and ProfitStars recommends at least three years of data for effective modeling. While most core processing system have the data elements for CECL compliance, scrubbing the data will be needed, and it is often difficult to extract historical information. Therefore, starting the collection process now to collect and correct your data files is key to building an adequate and accurate set of data for effective modeling.
Once you have your CECL solution provider identified and data requirements in hand, it is time to start getting your extracts built and run. Getting the data and scrubbing exceptions can be a time-consuming task but is essential in building a strong model and valid results. Inadequate historical data will negatively influence the accuracy and reliability of your CECL results. The two biggest data issues are an inadequate amount of history (less than one year) or poor data quality within your loan extracts. Both of these issues affect the ability to accurately predict reserves and losses.
Regulators suggest you should review your CECL model results "early and often". The CECL experts at ProfitStars agree and believe that understanding your CECL results at the portfolio, product, and account levels is key to understanding and validating your new reserve amounts.
After you have installed your CECL model and built history, you are finally ready to start seeing results! At this point, you will understand the CECL requirements compared to your current ALLL and can start planning for the impact. Knowing product- and instrument-level reserves can allow you to start examining product profitability based on new CECL reserves as well as determine profitability on new transactions based on both your ALLL (allowance for loan and lease loss) and CECL requirements. Not assessing your CECL requirements at the product and account levels can lead to bad pricing decisions on new business, negatively affecting your profitability after CECL adoption.
Now that you understand your reserves, after analyzing your CECL model results you can determine the "gap" between your current ALLL and your new requirements. Over time, you will improve your data quality, add additional data history, and "recalibrate" your model to more accurately predict your losses. This process of refining your CECL results will give you a more accurate assessment of your requirements and any gap between current ALLL reserves and CECL. This process of running your CECL model in parallel with your current ALLL model is essential in understanding differences and building confidence. Any CECL gap will likely come from your capital accounts. You are now ready to ask some important questions:
Understanding these questions is key – and the sooner you know the answers, the better you can plan for them!
After identification of any gap between ALLL and CECL, the next step is to determine how to resolve the shortfall. Most FIs can make a simple entry reclassifying capital to CECL reserves, however if this would make your capital "inadequate," then you might need to look for other methods to increase your reserves. Some FIs may adjust dividend policies and sell certain loan portfolios to reduce the reserve requirements and the hit to capital. Modeling your losses and determining any "gap" needed for CECL must happen early so you can develop capital plans. Late or bad modeling gives you a false sense of security and can result in a negative hit to your capital on your adoption date.
After completing the previous six steps, you will be well prepared to adopt CECL by your required adoption date. On this date, you will make the necessary accounting entries. You will also want monthly reports of your CECL requirements, and reports that allow you to understand how your reserves are changing each month based on new volume, payoff/pay downs, changes in economic conditions, and changes in the risk profile for your clients.
The information at your portfolio, product, and instrument level are now key pieces of data to both justify your reserves and also integrate into your business processes By taking a proactive view toward and CECL and the effective compliance date, you can be assured that you have picked the right solution, effectively scrubbed your data, and have a strong model that will pass regulatory scrutiny!
Understanding credit exposure is critical in order to remain competitive and profitable. The legwork that you put into preparing, understanding, and analyzing your FI's CECL requirements can also be used in helping your institution price loans, monitor portfolios, and budget for new volume (and associated reserves). Don't miss the opportunity to integrate your CECL results into budgeting and pricing solutions to drive profitability at your institution. CECL results can be used for much more than determining your reserve allocation adequacy. Your FI can also benefit from feeding CECL results into a budgeting, profitability, and pricing system. This helps you forecast new loan growth and effectively understand product and customer profitability within your new CECL reserves. Adding new loans and associated CECL requirements can also affect how you price future commercial loans. Getting your CECL results integrated into your other financial management processes is key to success. A disparate CECL model that doesn’t feed your budgeting, profitability, and pricing applications can add significant extra effort. Don’t settle for an inefficient process!
Going forward, FIs should conduct annual model validations to recalibrate their model and ensure ongoing accuracy in predicting potential credit losses. In addition to model recalibrations, models should also be independently verified by an outside party.
Having unbiased parties conduct these annual validations and check outputs helps ensure accuracy. And by adhering to this process, you will enhance the credibility of your institution’s model when it is reviewed by examiners.
ProfitStars® CECL DataStore and Validation℠ and ProfitStars® CECL Analysis and Reporting℠ are new hosted database tools that help FIs of any size comply with CECL. You gain:
You're on the way to CECL success!
Have questions in the meantime? Contact a ProfitStars® CECL expert today at 877-827-7101 or firstname.lastname@example.org.
Now is the time to begin preparing for CECL. Please fill out the form below to access important resources to help you get started. Take a look at our Top 8 Tips for CECL Success infographic, read our "The Timeline for Implementing CECL Has Already Begun" white paper, and learn more about the ProfitStars CECL solutions we offer to ensure your institution meets compliance.