Practical Approaches to CECL Methodology
CECL is intentionally non-prescriptive. Deciding on your approach to estimating your allowance under CECL, that is deciding on a compliant methodology or methodologies, will involve answering questions and addressing concerns unique to your institution. Still, how you eventually choose to estimate as well as the decisions you make along the way must be prudent and documented, “reasonable and supportable.”
Deciding on a CECL methodology is no easy task. And the degree of difficulty is somewhat compounded by a lack of regulatory direction beyond the initial FASB Guidance and follow-up interagency CECL summary Joint Statement and FAQs. CECL is intentionally non-prescriptive, and as our co-advisor Dorsey Baskin warns, CECL will be a dynamic standard requiring the agility to continually adjust your processes. “The FAS 5 standard release was a single paragraph and we’ve argued over what that means for 30 years,” Dorsey reminds us.
So while preparing for CECL includes complying with the FASB Guidance, it also involves answering many questions and addressing many concerns unique to each institution. That might seem highly subjective, but the lender’s feet will be held to a fire of objectivity. Not only how you eventually choose to estimate your allowance under CECL, but the decisions you make along the way must be prudent and documented, “reasonable and supportable,” according to the Guidance.
Deciding on a CECL methodology
As all lenders know by now, CECL will require more sophisticated analysis of more loan data. The 2017 MST annual lender survey tells us that most institutions believe they will require a CECL software platform to access and analyze data en route to determining a CECL-compliant methodology or methodologies. But you can’t answer CECL with a piece of software. It’s a management tool. Just adding software as the answer to CECL is like throwing darts blindfolded; you’re not likely to hit the bulls-eye.
A lender is responsible for implementing a methodology that is consistent with its loan portfolio, with its shareholders’ interests, that accommodates its internal allowance processes. You must determine the broader impact of CECL on the institution, including the need to address governance and controls, CECL’s likely impact on capital and the related need for capital planning, even the types and terms of loans you are willing to offer given you will have to book losses from day one of your loans. Determining that takes time and analysis. And what the software does is make the analysis doable – efficient, with reliable accuracy and within a reasonable time frame.
Allowance software and advisory services work in concert
Implementing a third party allowance software solution is part of the larger initiative involving a series of processes, which we call the CECL Blueprint. It begins with a current-state assessment and a data gap analysis. Your data will lead you to where you need to be. Key to identifying a suitable methodology is using the same set of clean, accurate data to test methodologies in order to compare and contrast them with your current allowance as well as against each other.
Modeling for CECL
The only way to get a clear picture of which methodology – or methodologies – is best for your institution and portfolio is to model your options over several periods. How does each respond in comparison to your current estimation results? What do they reveal about your credit environment and what will that environment look like if you settle on this or that methodology? And how over time, will each impact your balance sheet, capital and operations?
The practical CECL project involves running those parallel processes, shadow analyses. As you determine the most suitable methodology, you’re also getting all the data into the system, getting it all to balance, and getting users comfortable with the new software tool you’ll use for CECL.
Testing different methodologies will also alert you to changes you might need to make in your loan portfolio and underwriting, give you time to address weaknesses that could be costly under CECL. It will take years to run off riskier loans that will require additional reserves and replace them with lower risk loans. If you don’t do the analysis beforehand and start making those changes in your lending now, the expense at CECL implementation could be painful.
Installing a CECL software platform and addressing CECL transition concerns are projects that share top priority in CECL preparations. The demand by lenders for technology and expert guidance is currently manageable in terms of available resources. However, finite professional and technical expertise will command higher fees as the call for assistance with CECL reaches a crescendo. Thus, “best practices” include acting now on both fronts to control costs and ensure access to critical resources.