CECL Methodologies for Small Institutions: Agencies Make Recommendations
On February 27, representatives of several regulatory agencies, including the FDIC, FASB and the SEC, hosted a webinar to offer sample CECL methodologies considered appropriate for “smaller, less complex” financial institutions. The speakers referenced three methodologies: snapshot or open pool method, remaining life method and vintage method.
What the regulators referred to as a “snapshot” or “open pool” method is what the industry has been referring to as the “cohort” method. The methodology, as defined by the regulators: “ … takes a snapshot of a loan portfolio at a point in time in history and tracks that loan portfolio’s performance in the subsequent periods unit its ultimate disposition.” – a reasonable and anticipated to be a widely adopted approach to CECL. The vintage method tracks losses by year of origination, and as CECL requires you to estimate losses over the life of the loan, starting from its origination date, vintage can appear a particularly appropriate methodology. However, although one of the more widely demonstrated CECL methodologies, in our work advising institutions on their transitions to CECL, we’ve discovered that the applicability and/or reasonability of this approach has its limitations for many institutions.
On the other hand, a “remaining life” methodology, also referred to around the industry as “weighted average maturity,” has only recently gained recognition as a potential CECL methodology – and mainly as a result of the agencies’ February 27 “Practical Methods” webinar.
The remaining life method allows institutions to use the annualized loss or charge-off rates they’ve been employing in their incurred loss estimations as a basis for their CECL allowance for credit losses (ACL). That is, they can take their annualized loss rate and convert it for life-of-loan application. The basic formula for a remaining life involves multiplying the annualized loss rate by a weighted average maturity figure to come up with a life-of-loan expected loss. Losses do not follow a linear pattern; they will taper off as loans close in on maturity. So, the remaining contractual life of the loan is adjusted by the expected scheduled payments and prepayments. The expected loss then is obtained by multiplying the average annual charge-off rate by the adjusted remaining life of the portfolio.
Institutions have been asking regulators for a method for converting annualized loss rates for a CECL estimate. The regulators have responded with the remaining life option. But there are still questions about whether or not this method is appropriate for most institutions. Is it a case of oversimplification? Does a remaining life estimation get you where you want to be, to a true and useful CECL estimation? Other approaches might be preferable, such as a cohort method, which still relies heavily on historical loss data, or, if you have a software solution, perhaps a more sophisticated model leveraging a transition matrix-based approach.
A Confusion of Terms
The allowance is dogged by confusing terminology. ASC-450-20 and ASC 310-10-35 replaced FAS 5 and FAS 114 respectively as loan impairment guidance almost a decade ago, yet for many, the old terms remain in use, perhaps because they’re easier to remember – certainly easier to say. With the new standard, we’re being tested again. Not only do we have to learn a new way to estimate our allowance, we have to work our way through the accompanying word jumble and competing acronyms. While the guidance is officially ASU 2016-13, we commonly refer to the new standard as “current expected credit losses” or even more broadly, “CECL.” CECL is also known in circles as the “life of loan” model (hopefully not soon to be referenced as “LOL”).
With CECL, we will no longer be estimating our “ALLL,” our “allowance for loan and lease losses,” but our “ACL,” our “allowance for credit losses.” Of course, ACL is more accurate as CECL applies to a broader array of financial instruments than did the incurred loss model. And neither will we be making a “provision,” but an “expense to credit loss,” which has already achieved acronym status as “ECL.” And is “discounted cash flow,” or “DCF,” a model, a methodology or more than one of either that collectively generates an expected credit loss, excuse me, an ECL. Even “model” and “method” are being used interchangeably.
Hence, what the regulators in their February 27 webinar referred to as “remaining life” is the same as “weighted average maturity,” and “snapshot” or “open pool” what we know as “cohort.”
So, would it be too much to ask the FASB, FDIC, SEC and OCC for some clarity in terminology? Let’s have a new interagency guidance on standardization of terminology, or “SOT,” so to speak.
If we can help you ‘define’ CECL, contact us here. MST empowers financial institutions with confidence in their allowance estimates through education, advisory services, and software solutions.