What Did Last Week’s Interest Rate Hike Mean in a CECL Environment?
Last week the Federal Reserve moved to raise interest rates by 25 basis points, a quarter of a percent. The FOMC characterized the increase as a response to an anticipated rise in inflation to more normal levels and a healthy employment picture.
The rate increase triggered a series of actions in financial institutions, the kinds of activity that typically occur at times of changing interest rates: adjustments to floating rate assets and liabilities, changes to client billing, discussions among rate committees about changing offered rates and so forth. In addition to such commonly executed moves, we considered the new CECL allowance accounting environment and what kinds of actions rising interest rates might bring to institutions’ allowances once the new standard is implemented.
Interest rates drive changes in prepayment speeds. For years, lenders’ treasury and asset liability management departments have examined these changes and modeled how they affect their cash flows. Now the group charged with estimating the allowance under CECL will have to include consideration of the effects of interest rate changes into their forward-looking calculations.
Theoretically all financial institutions saw their CECL allowance balances rise with the interest rate hike. The CECL methodology requires a reserve calculated for the life of the asset. As rates move up, prepayment speeds are expected, and usually modeled, to slow down. This means the lives of those assets just got longer – and longer lives mean higher reserves.
What should financial institutions consider in regards to CECL with the interest rate hike?
How much has the rate change increased your institution’s asset life? How much higher will your reserve balance be considering those aging assets? How much will earnings and capital be affected? Which assets will be modeled with longer lives? These are all questions lenders should consider in advance of CECL. Asset lives, the associated prepayments, and other aspects of the allowance are certain to see new levels of volatility under CECL and need to be examined as part of your CECL preparations.
MST provides a comprehensive set of ALLL and CECL advisory services and software solutions. Tailored to your financial institution’s needs, Advisory services address all aspects of the allowance, including projects required for a successful, efficient transition to estimating under the Current Expected Credit Losses (CECL) standard.
About the Author
Shane Williams is a Senior Advisor in Modeling for MST Advisory. He 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. To contact Shane, email firstname.lastname@example.org.