On Tuesday, February 27th the FDIC and the Federal Reserve Board (FRB), in conjunction with the Financial Accounting Standards Board (FASB), the U.S. Securities and Exchange Commission (SEC), and the Conference of State Bank Supervisors (CSBS), recently hosted a webinar to discuss how smaller, less complex financial institutions can implement CECL. The purpose of the webinar was to help small financial institutions go from theory to application as they prepare for CECL and to dispel myths often associated with FASB’s new standard.
The webinar introduced various spreadsheet-based, CECL compliant loss rate methods. It also provided a starting point for institutions to estimate CECL. The organizations then shared their perspectives regarding data, process, and controls.
Currently, with GAAP, loss rates require an unadjusted historical charge-off experience, followed by qualitative adjustments. That amount is multiplied by a loss emergence period and loan category balance to calculate ALLL. Under CECL, the loss emergence period is removed and the unadjusted historical charge-off experience is calculated over the life of the loan, instead of annually under FAS 5.
The webinar presented three, spreadsheet-based methodologies for community banks calculating the ALLL; however, it did not recommend a specific method or give a comprehensive list. Banking institutions need to conduct a situational analysis to determine which methodology is best for them. While it may be possible to use an Excel spreadsheet for CECL calculations, housing and maintaining loan-level data may require more sophisticated systems. Additionally, financial institutions will find it difficult to employ certain methodologies in a spreadsheet-based model, and if the institution can not scenario-test all methodologies for all pools, the institution runs the risk of higher credit loss reserves. CECL automation conversely gives the bank flexibility to quickly test different methodologies by pool and select that which is most representative of their loss.
Snapshot/Open Pool Method
The first method discussed was the open pool method. The snapshot/open pool method takes a snapshot of a loan portfolio at a point in history and tracks that loan portfolio’s performance in the subsequent periods until its ultimate disposition. Charge-offs in the subsequent periods are aggregated to derive an unadjusted lifetime historical charge-off rate. Total charge-offs associated with the snapshot loan portfolio are divided by the snapshot loan portfolio balance to provide the lifetime historical charge-off rate associated with the snapshot loan portfolio.
Remaining Life Method
The next loss rate method analyzed was the remaining life method. The remaining life method utilizes average annual charge-off rates and remaining life to estimate the allowance for credit losses. For amortizing assets, remaining contractual life is adjusted by the expected scheduled payments and prepayments. The average annual charge-off rate is applied to the amortization adjusted to the remaining life to determine the unadjusted lifetime historical charge-off rate.
Lastly, the vintage method was discussed. Vintage refers to the year of origination. This method tracks all charge-offs associated with a specific vintage. Borrowers’ historical charge-off patterns are used to estimate future losses. To calculate, for example, the total charge-offs related to > year 2000 originations are divided by the total amount of >2000 originations. This provides the lifetime historical charge-off rate associated with >2000 vintage.
Challenges and Considerations
Webinar presenters noted that financial institutions may face some common challenges when using the new loss rate methodologies. Challenges could arise when an institution’s losses are minimal or are sporadic with no predictive patterns. Other circumstances in which significant adjustments may also have to be made included:
- when data is only available for a short historical period,
- when the current portfolio composition varies significantly from historical portfolios, or
- when there is a low number of loans in each pool.
Changes in the economy should also be addressed in estimations, the webinar leaders said.
A central tenet of the CECL model is that allowances are based on losses over the lifetime of a loan. Webinar leaders noted that CECL allowances should be measured using relevant data about past events, including historical loss experience, current conditions, and reasonable forecasts. The availability of this data will be a factor to consider when selecting methodologies. This is where third-party vendors can bring value in preparing for CECL.
The objective of CECL is to report management’s best estimate of losses as of the reporting date. Webinar leaders emphasized that there is no single required method to determine losses. Understanding the data used and model selected is key for a successful transition. Judgment will be necessary to develop, document, and apply a systematic methodology for determining an estimate of current expected credit losses. Existing procedural discipline is a useful starting point, they added.
As first steps, regulators and the standard setters recommended that financial institutions review the Accounting Standards Update 2016-13, Topic 326, Financial Instruments–Credit Losses. Core CECL guidance can be found on pages 101 through 123 of the ASU. Other recommended resources were the Joint Statement on the New Accounting Standard (ASU) on Financial Instruments–Credit Losses from June 17, 2016, and the Interagency FAQs. When first starting to prepare, it will also be useful to create a cross-functional CECL team and a CECL project plan.
Recommended next steps were to discuss the various methodologies for calculating ALLL to see if they seem feasible and align with existing processes of the financial institution. This will also mean conducting an analysis to see if the appropriate data is available to make the calculations. An institution should consult its auditors/regulators to discuss plans. In sum, webinar leaders noted that it is important for institutions not to wait and begin preparing for CECL now.