Assessing Prospective CECL Methodologies: Adjusted Annual Loss Rate
The road to CECL compliance ends in identifying the CECL methodology (or methodologies) that best suits the institution and its loan portfolios as well as complies with CECL guidance and regulator demands.
FASB has been steadfast in not specifying or even identifying all appropriate CECL methodologies. Because each institution is different, with different types of loan portfolios and different underwriting principles, the method or methodologies you choose must be determined by your unique blend of products, portfolios and markets as well as the quality and quantity of your available loan level data.
That doesn’t mean a lender must rebuild its methodology totally from scratch, only that it must choose a methodology for each loan pool based on its own judgment and circumstance. Most institutions have been relying on historical loss analysis that derives average annual loss rates to estimate their allowance under the incurred loss standard, but under the new rule that approach may be phased out. Given the need to adopt a more sophisticated methodology that computes and makes use of life-of-loan loss rates, most institutions will have to consider whether they can continue to use average annual loss rates and in what circumstances such might continue to be applied.
For insights on prospective CECL methodologies, we asked the advisors of MST Advisory, consultants helping lenders through the discovery and decisions that will lead to choosing and implementing a CECL methodology.
Adjusted Annual Loss Rate
Complying with CECL currently means adhering to the limited guidance in the FASB’s accounting standard update while waiting for any additional guidance that may come from other sources such as the FASB’s Transition Resource Group, the AICPA’s Depository Institutions Expert Panel or, less formally, from industry trade groups. One key aspect of the new FASB standard is that CECL will require lenders to estimate losses from day one of a loan through its entire life, to pay-off or charge-off. Inherently, then, FASB has set a bias toward estimating based on an adjusted life-of-loan loss rate as opposed to an adjusted annual loss rate.
“There are pros and cons to either approach,” Dorsey Baskin noted. “The decision may be driven by the availability of data, at least until sufficient life-of-loan data can be accumulated.”
An adjusted annual loss rate could be compliant, he pointed out, but it seems to be most appropriate in the Discounted Cash Flow (DCF) model for estimating loan losses and its application in other models may be acceptable only for a few years until the lender can accumulate sufficient data for reliable life-of-loan model inputs.
To use an adjusted annual loss rate methodology, some steps that will generally be needed include:
- Assemble average annual loss rate data, including knowledge about the circumstances surrounding those losses
- Determine expected loan run-off considering expected future conditions
- Adjust the historical loss rate experience for asset/institution specific factors and the run-off of the pool, considering the institution’s reasonable and supportable forecast.
“The adjusted annual loss rate allows a lender to estimate future losses based on a summation of forecasted annual loss periods that, taken together, extend as long as the expected life of the loans in a certain pool.” Baskin said. “Even lenders with limited data might be able to estimate under this approach as the data is the same they are using to estimate under the current incurred loss model.”
A benefit of the shorter measurement periods used for annual loss rate derivation is that they will generally make coming up with strong statistical correlations with loss -affecting factors to be easier than will be possible with longer life-of-loan loss rates, that is, the typical loss-affecting factors are likely to change less during annual measurement periods than over longer periods.
“The ability to make strong statistically supported adjustments for relevant factors will be affected by the duration of different types of loans,” Baskin said. “For one-to-three year loans, for example, that might not be a significant issue, but for single family, 30-year mortgages, it could be very important.
“Lenders using an adjusted annual loss rate to estimate their CECL allowance will have to make accommodations for different loan vintages, as varying vintages will not be evident in annual loss data and the use of unadjusted annual loss rates could result in overestimation of expected losses. As the FASB and its staff have pointed out, the loss on a static pool of loans over its remaining life is not equal to a pool’s annual loss rate multiplied by its life in years.
“One reason for this is that the annual loss rate typically includes charge offs of loans of various vintages within the pool,” Baskin continued. “And we generally observe that charge-off rates change over the life of a static pool. Thus, the annual average loss rate for the historical mixed-vintage pool has less and less applicability to a static pool as it ages. Under CECL, because the loss estimate is to be made only for the loans (and unfunded commitments) on the books at the balance sheet date as they run off over time, that static population of credit exposures will age and change. It is for this reason that life-of-loan loss rates are generally lower, and more accurate, when applied to a static pool than would be the multiplied average annual loss rate.
“Average annual loss rates may be the best (only) information available for some lenders for a few years,” Baskin concluded. “But lenders should be very careful in its use, understand its limitations, and make appropriate adjustments.”
Read the blog on using Vintage as a prospective CECL methodology.
Read the blog on considering PD/LGD as a prospective CECL methodology .
About the CECL Methodology Panel
Dorsey Baskin is recently retired from the National Professional Standards Group of Grant Thornton LLP and serving as an independent consultant to MST Advisory clients. His roles at Grant Thornton included national leadership of the firm’s innovation function, technical accounting and audit advisor for the banking industry audit and consulting practice, and national professional practice director.
Shane Williams, a senior advisor for MST Advisory, works with banks and credit unions to set priorities, identify data needs, implement allowance technology, run shadow analyses and identify appropriate methodologies in preparation for accounting for loan losses under CECL. Shane counts more than 25 years of financial and risk management experience as a banker, in software development and delivery, and as a consultant to major financial institutions.
For more than 30 years Shelly Biggs has provided leadership in risk management expertise as an executive with and consultant to the nation’s largest financial institutions. Her areas of expertise include: Development of risk and reporting framework, ALLL, CECL, corporate finance (quarterly SEC reporting), reconciliation of finance and risk data, regulatory reporting and earnings call reports. Shelly is an advisor with MST Advisory.