4 Methodologies to Consider Under CECL
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While FASB will not specify a methodology for estimating the allowance under CECL, advisors are telling banks to begin testing models and comparing results with their current incurred loss estimations. As a form of shadow analysis, testing could help the bank determine which model to gravitate toward for CECL as well as provide an idea of the impact on capital, staffing, external support and other areas as well as the allowance.
“A methodology that will give the bank better, more granular data will help it prepare for the new requirements,” Chris Emery, MST Director of Special Projects, said. “A more sophisticated methodology than it is using to estimate under the incurred loss model could help the bank start building some of the underlying structure that CECL will require. The bank will need to be more forward-looking in its analysis. The data the bank gathers today will remain useful for several years.”
According to Emery, the most important consideration in transitioning to a different methodology is the type and
amount of data required to make the change. He suggests the bank consider two types of methodologies:
1) Loss Migration
Calculating loss rates based on the migration of losses back through the history of a loan in order
to assign the losses to risk-stratified segments allows for more granular analysis of loss rates based on risk characteristics.
2) Probability of Default/Loss Given Default (PD/LGD)
The method combines the calculation of the probability of loans experiencing default events with the losses ultimately associated with the loans experiencing those defaults.
Steven Lackowski, manager of Grant Thornton’s National Financial Services Advisory Practice, used the MST 2015
National Conference to offer additional approaches to expected loss modeling.
Similar to loss migration, the method involves grouping loans outstanding at the beginning of a loss accumulation period by relevant risk characteristics, and measuring losses accumulated on each “cohort” over the following loss
The method involves tracking homogeneous loans on the basis of calendar year or quarter of origination and measuring losses accumulated on each “vintage.”
FASB has set timelines for CECL implementation, so during the next couple of years CECL preparation is key. Testing different methodologies with shadow loss analysis can put your bank or credit union ahead of the curve. The main idea when looking at different methods for calculating the allowance based on current expected credit losses is to test, test, test. This will also give you, as a banking professional, the ability to dig into why the outcomes are different and see which methodology is best for your institution.
For the most up-to-date information regarding CECL and the impending deadlines check out our most recent blog posts.