In the previous post about preparing for your CECL compliance deadline, we looked at the steps needed to analyze the credit risks within your loan portfolio, and clarify the credit quality indicators (CQIs) impacting those risks. These first two steps of this complex, lengthy lead up to your early or required implementation date should have provided you with a solid understanding of the composition of your loan portfolio.
You should now be prepared for Step Three: Selecting the Appropriate CECL Model(s). FASB has outlined numerous approaches for calculating the required reserve. In this step, you will determine which of the model(s) will be most appropriate for each loan pool based on a list of current and historic factors.
How to Determine the Right Model(s)
FASB guidance outlines multiple different models that apply to different facts and circumstances. Keep in mind that under the new CECL standard, there is no one-size-fits-all solution. Some cases will require a sophisticated model to forecast potential future losses. In other cases, the approach you are currently taking will remain appropriate, as long as a forecasting method is implemented.
For each loan pool, determine the complexity by first assessing and documenting all supporting information regarding:
- Historical loss experience
- Level of concentration
- Risk profile
- Size of the loan pool
Even with the significant changes, historical knowledge still plays a key role in your calculations. In addition to your loan pool assessment, your institution will need to take into account broader economic indicators for the market you serve. These known and presumed data points should be considered in the context of their level of correlation to actual losses to project your expected losses in the forecast period (especially as it relates to years one and two).
The guidance provides upwards of 14 models that banks can use to approach calculations and applications to each loan pool. These options include:
- Component loss model
- Discounted cash flow
- Loss-rate model
- Probability-of-default method
- Roll-rate model
- Vintage analysis model
Most banks are likely to have two or three models running in a portfolio at any given time. This large number of model options may seem overwhelming but it highlights one of the opportunities of the standard—flexibility. One key benefit of CECL is that it offers the ability to perform estimation with a higher level of specificity and relevance to your specific loan scenario—ostensibly lowering your risk.
The best way to determine which model you need to use for any particular transaction is to pick the one that both coincides with what you’re doing currently, and that is appropriate to the simplicity or robustness of the portfolio. It’s important to recognize that each model option will present unique benefits and weaknesses. The more you understand those details, the better equipped you will be to make the right decision about which model (or models) to use to manage the different pools in your portfolio.
To recap, we have detailed how to:
- Analyze the concentration exposure risks within your loan portfolio
- Clarify the credit quality indicators (CQIs)
- Select the appropriate CECL model(s) for each loan portfolio
Next week, we will look at how to assess your resource capabilities and needs. This is a big consideration that has cross-functional implications for your institution. We will help you understand how to assess your human and technological capabilities and needs, and to identify the external resources necessary to improve efficiency and internal controls impacted by CECL.
The HORNE CECL series includes several resources, including a webinar and visual eight step timeline to educate you about the standard, its impact on the banking industry, and what you need to do to prepare for the changes. Over the coming weeks, we will use the blog to look more closely at each of the individual steps. These are posts you will want to bookmark for reference so you can refer to the information as you get farther into the process.
Remember that you can access our complimentary one-hour webinar anytime for more help with the steps and tactics involved in working toward compliance. Watch the CECL: Turn Compliance into Opportunity on demand.
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