August 1 — With the deadline looming, tips for CECL prep are coming from all sides. Having trouble sorting through it all? Here are some practical tips to keep your institution on track.
Capture a wide range of data points during underwriting and credit administration to allow for flexibility in deciding what methodology or methodologies to use under CECL. Internal data is superior to external data when estimating components of the allowance for credit losses, but external data is superior to guessing. When using peer data or industry data, an institution should use the results to provide inputs to estimate its own predicted experience (rather than at the output level).
Determine if your data is adequate by comparing your current data availability to the data that is required or useful under the new accounting standard. Additionally, understanding loan-level data collection requirements helps institutions prepare for CECL. Data should be captured on a period basis to minimize compliance risk and adequacy concerns.
The ALLL calculation process must be well-documented and consistently applied to establish a defensible calculation that will satisfy examiners. Communicate with auditors, regulators and your institution’s board of directors to prepare for the CECL transition. It is also important to the use the appropriate loss rate method for ASC 450-20/FAS 5 loans to ensure accurate ALLL calculations. The ALLL calculation process must be well-documented and consistently applied to establish a defensible calculation that will satisfy examiners. Using carefully considered, defensible quantitative analysis rather than a heavily qualitative model should result in a defensible allowance.
Build the ALLL model to be flexible at the institution so it is possible to try different tweaks to the model, i.e., to look-back periods or segmentation, without significant rework.
Review your current allowance and credit risk management practices to identify what can be leveraged when applying the new CECL standard. PD/LGD methods, including PD/LGD/EAD DCF projections, can offer ways for community institutions to leverage externally supported inputs when first-party experience produces meaningless results. Risk ratings are recommended for allowance calculations under CECL because they are one way that institutions can sub-segment their portfolios.
Do not build up reserves in anticipation of CECL — continue to reserve according to GAAP’s incurred loss model until your institution’s CECL implementation date. Many institutions are producing CECL expectations that are less than their current allocation level under incurred loss practices.
In order to forecast loss under CECL, it is important to understand economic trends by using FRED data or other sources. If the forecasted environment does not differ from recent conditions, use recent conditions to estimate allowance for credit losses. If the forecasted environment is different from recent conditions, use information from relevant periods. Consider a window of applicability rather than a look-back window.
CECL requires consideration of not only past events and current conditions but also reasonable and supportable forecasts that affect expected collectability. It is important to become familiar with vintage analysis, as it may become a minimum requirement when calculating and documenting an ALLL calculation under the new guidance. Your institution may need to redesign your calculation processes and data storage systems when preparing for CECL.
Multiple people in your institution should understand and be able to perform the ALLL, ensuring consistent (even if staffing changes) calculation accuracy and defensibility. When calculating the ALLL under CECL, the expected life of each segment and/or prepayment behavior will need to be determined before performing any calculation. Staff can familiarize themselves with CECL requirements indicated in topic 326 of FASB’s accounting standards update.
Under the new standard, the allowance for credit losses may be determined using various methods such as discounted cash flow methods, roll-rate methods, probability-of-default methods or methods that utilize an aging schedule. The discounted cash flow technique is not required, but it is the most defensible approach to estimate the collectibility of future cash flows due to its highly auditable framework and methodological alignment with CECL.
With the CECL transition, it is important to form a CECL committee with clearly defined roles and responsibilities in the beginning stages of planning to avoid future complications. This may include evaluating automated solutions to reduce dependency on spreadsheets and manual calculations during the transition. An automated solution may better capture loan level detail and calculate ALLL.
Implementing and managing timelines to ensure that your institution meets its required date for CECL implementation is also necessary — 2020 for SEC filers and 2021 for all other entities. Identify new procedures, such as the creation and approval of life-of-loan calculations, and changes to current procedures in preparation of CECL, and ensure these are documented in the institution’s policy.
Attend industry events to find out how other institutions are tackling CECL implementation challenges.