CECL Governs the Loans Lenders Make Today
How many loans do you originate with a maturity of more than three, five or 10 years? The new CECL allowance accounting standard will require a paradigm shift in the way those loans are handled. The longer the terms, the more impact CECL will have on your allowance and bottom line. How much impact? It would be wise to determine that now, as you originate new loans, as opposed to being surprised when you do your first allowance estimation under CECL in three to four years.
Four key variables affect the allowance forecast in an expected loss estimation.
Preparing for CECL means understanding how those variables will play in your institution:
Balance. How you group your loans, that is, your loan pools, will substantially affect your CECL allowance. Due to CECL’s “life of loan” provision, a loan-to-value analysis should be included in any pooling exercise, allowing you to pool loans with fewer years to maturity that will be at less risk of default. One large loan defaulting at 90 percent to value could dramatically increase the expected loss for an entire pool for an extended period.
Probability of Default (PD). PD measures the chances that a loan goes bad. It is expressed as a percentage of the loans in a pool excepted to default.
Loss Given Default (LGD). As opposed to how many loans expected to go bad, LGD measures the amount of loss – how bad the loss is.
Life of the Loan. CECL requires you to determine expected losses for a loan from the day it closes throughout its history. While the expected loss declines year to year as a loan matures, the longer the term the bigger the associated reserve. Shorter-term loans will be less painful to earnings and capital.
Testing is methodologies is key in transition to CECL.
To project CECL’s impact on your portfolio, you will have to test various methodologies, which is best accomplished by running concurrent or “shadow loss” analyses along with your current incurred loss estimations. But the only way to test is to have the data you need for different CECL allowance scenarios – and different methodologies require different amounts and types of data. If the data you need to execute a preferred methodology is not already in your system, then your first priority is to gather that data. For most institutions, that means unearthing and scrubbing as much data as they can find internally, then supplementing it in some way, perhaps with peer data, then making assumptions to fill gaps.
Running shadow loss analyses will not only help you determine what methodology you might use under CECL but what kinds of loans you are willing to offer. The longer a loan is on your books, the longer you will have to account for the possibility of a loss. Pre-payment and extension risks are very different for floating rate and fixed rate loans, and affected by interest rate moves, which also must be considered as part of CECL’s forward-looking requirement. A lender might opt for more balloon mortgages to shorten the lives of loans. You might consider originating 30-year mortgages then selling them to Fannie and Freddie as opposed to holding them. Or you might consider your balance between floating rate and fixed rate loans. All decisions that are driven by CECL’s life-of-loan variable.
Automation software like the MST Loan Loss Analyzer lets you quantify those variables, formulate pools by asset lives and see those implications, do prepayment and extension analytics, test and identify methodologies and what you need to be able to use them, and build the documentation you need not only to decide on how you will estimate your reserves under CECL but to defend it as reasonable and supportable.
Getting started, determining priorities and learning what information you will need and how you will get it is imperative. If you put it off, it’s going to be expensive, both securing the resources and support to make the transition as well as the impact on earnings and capital.
As a senior consultant for MST Advisory, Shane Williams 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. Following two decades as a treasurer with a national bank, he worked with FiServ helping lenders implement financial services technologies, then as a consultant to bankers with Price Waterhouse Cooper.