We have discussed the essentials of CECL in a previous post in which we explained the new requirements. Below we show a simple path toward CECL compliance which may serve as a catalyst toward more refined and robust methods.
The deadlines for CECL compliance are fast approaching. As many institutions continue to struggle with settling on a strategy, many unknowns remain and will continue to remain until implementation is in effect for a period of time. As institutions continue to study strategies of how they will manage the new processes, it may be possible for many institutions to choose a less complex path and become compliant while continuing to refine and enhance their methods.
The Fed, the FDIC, the CSBS, the FASB and the SEC conducted a webinar discussing CECL implementation for smaller, less complex community banks in February, 2018. The perceived purpose was to dispel the myth that community banks will be required to perform complex modeling techniques in order to comply with CECL.
The regulators involved in the webinar provided three loss rate methods that are simple enough to calculate using a spreadsheet. Below, we present and explain one of the methods as a less complex solution to CECL implementation.
The Snapshot/Open Pool Method
The snapshot/open pool method takes a snapshot of a loan portfolio at a point in time and tracks the performance of the loans included in that snapshot through the life of each loan. Annual loss rates from this pool are aggregated to create a lifetime charge-off rate.
For example, suppose a bank’s consumer loan portfolio has an average life of three years (contractual life adjusted for prepayments and debt restructuring). Furthermore, suppose the outstanding balance of the consumer loan portfolio is $5,000,000 as of December 31, 2015. If we “snapshot” the loans that makeup this balance and track their performance, we may find a result that resembles the data shown in table below.
In the first year, the charge-off rate is 0.36% (calculated as $18,000/$5,000,000). In the second year, the charge-off rate is 0.29% (calculated as $14,500/$5,000,000). In the third year, the charge-off rate is 0.18% (calculated as $9,000/$5,000,000). Thus, the lifetime charge-off rate of the snapshot is 0.83% (calculated as 0.36% + 0.29% + 0.18% OR ($18,000 + $14,500 + $9,000)/$5,000,000).
This calculation only provides the historical lifetime charge-off rate that can be used to calculate the lifetime expected loss rate for future portfolios. This rate still needs to be adjusted for qualitative factors that will affect future charge-offs. This, of course, is the real issue and likely a primary impetus for the changes dictated by CECL – quantification of qualitative factors. However, this method provides a starting point for community banks to comply with CECL.
Is this Methodology Best for My Institution?
We’ve discussed previously that other CECL methodologies may offer additional benefits to the bank aside from CECL compliance. For example, our preferred methodology, the probability of default/loss given default methodology (PD/LGD), though more demanding quantitatively and in terms of data required, can pay dividends. These include a more precise pricing strategy, more efficient capital management, and greater profitability in addition to CECL compliance.
In addition, the modeling process required by the PD/LGD method provides a way to address the challenge of quantitative factors by providing a quantification method. Given the changes that CECL presents for banks, each institution should holistically evaluate CECL methods not only with respect to compliance but also how the requirements can be leveraged to be beneficial with respect to efficiency and profit.
How to cite this blog post (APA Style):
Premier Insights. (2018, September 6). Achieving CECL Compliance in One Easy Lesson [Blog post]. Retrieved from https://www.premierinsights.com/blog/achieving-cecl-compliance-in-one-easy-lesson.