More Insight on the Remaining Life Method for CECL Estimates
On April 11, all of the financial institution regulatory agencies came together for an “Ask the Regulators” webinar. Since the release of the CECL standard, the agencies have done several of these, with the emphasis generally seeming to be on how the guidance can and should be interpreted and implemented by community financial institutions.
This particular webinar focused on the Weighted Average Remaining Maturity (WARM) method for calculating a current expected credit loss (CECL) reserve. This method, also commonly known as the “remaining life method,” was first discussed in a similar regulator-led webinar in February of 2018 and has picked up considerable momentum over the last few months as institutions have gotten farther along the path toward completing their adoption efforts. The staff at FASB also addressed this method in a FASB Q&A document published on its website in January 2019.
Between the regulator webinars, FASB’s Q&A, and Abrigo’s own resources on the WARM method, some financial institutions are already aware of the mechanics and principles behind it. In this post, we highlight a few takeaways from the information that was presented on the webinar, especially in key areas that previous materials may not have fully covered.
Applicability of the WARM method
Given the perception of the WARM method as a simpler or less complex approach to CECL, the question weighing on minds at many institutions has been if this method could or should be applied to their portfolio. The regulators during the webinar did not offer any definitive guidance on this front. Instead, they repeated their regular messaging about how this method is “one of many acceptable methods” and could apply to “smaller and less complex” institutions or pools or assets. They were also very clear that while this method is an acceptable one, it should not be considered a “regulator preferred” or “safe harbor” method. Despite these typical regulator caveats, it should be noted that the regulators seem to have spent more time and effort on this method than any other single method at this point.
At the very least, this may give us some indication of the number of institutions that may fall into the classification of being “smaller and less complex” and for which this method may form a good starting and potentially ending point.
Balance projections in the WARM method
Under either of the WARM methods shown in this webinar, there are three basic components that make up the CECL estimate: annual net charge-off rates, adjustments for current conditions and reasonable and supportable forecasts, and a period-by-period projection of the expected balance of the pool over its remaining life. Net charge-off rates are relatively straightforward, and we’ll address adjustments in the next section, but the balance projection portion of this method had been somewhat glossed over in the original February 2018 regulatory webinar that covered this method. In this webinar however, the presenters were very clear in expressing that that this was “probably the most difficult part of this calculation.” Considering that CECL requires adjustments to the contractual lives of assets based on prepayments, it is not necessarily a trivial exercise to project what the “ending balances” of those loans will be on a periodic basis. On the webinar, they suggested getting this information from your loan system or asset/liability management process. Other options that Abrigo consultants have advised leveraging to project these future at-risk balances include using periodic or life-of-loan attrition rate curves based on the historical runoff rates of the loans. However an institution chooses to derive this information, it should expect for this part of the estimate to receive equal audit and regulatory scrutiny to the other estimate components because it is a key component of the WARM method that can have significant impacts on the ultimate results.
Qualitative factors in the WARM method
A key component of the CECL standard is the capability of institutions to make adjustments to their allowance based on reasonable and supportable forecasts, rather than relying current conditions as of the balance sheet date. In the February 2018 webinar, adjustments to the WARM method were largely reduced to a single adjustment factor at the end of the calculation, with not a lot of time being spent on explaining that part of the calculation at that time. The agencies clearly heard that as a feedback item, because there was significant time spent on the issue this time around. However, much of that emphasis was on the principles and continued applicability of qualitative factors, and not necessarily around the mechanics of applying these factors in the WARM method. Many of the points discussed are points the regulators have made previously: qualitative factors continue to be relevant under CECL; local institutions do not have to use national factors that do not have relevance to their lending market and footprint; and smaller and less complex institutions do not have to use complicated econometric models or employ a vendor to implement CECL. Emphasis was also placed on the point that the new reasonable and supportable forecast in CECL does not have to be a quantitative calculation proved out by correlations, but can be a qualitative process that uses documentation, much like institutions use today. At Abrigo, we have seen that the WARM method can be flexible to using a variety of different methods for applying these adjustment factors, from econometric regression modeling to historical “period picking” to pure qualitative overlay approaches.
In summary, the regulatory agencies certainly seem to be spending a great deal of time and effort on explaining and promoting the WARM method as an “acceptable method” for calculating a CECL allowance. The FASB also mentioned they were going to be performing additional institution outreach specific to the WARM method, including a workshop in the next few months that they encouraged institutions to reach out to the FASB staff to attend. It does appear the regulatory agencies are really committing to making sure this new standard is indeed scalable to the largest and particularly, the smaller institutions in their constituencies, which may be where the WARM method is most applicable. Any institution that has not fully committed to a CECL calculation approach would be well served by adding this method to the evaluation process to determine if it might be right for them.
For more information on the remaining life method, join a webinar hosted by Abrigo, “CECL WARM Method – What to Know and How to Use it.”