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5 Things You Need to Know About CECL

Posted by Brad Dahlman

Oct 11, 2017 4:00:00 PM

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Current Expected Credit Loss (CECL) is far more than just a new Financial Accounting Standards Board (FASB) regulation to achieve regulatory compliance. The active credit management and integration of the potential credit losses to your financial institution (FI) is key to how you should be running your organization in the years to come. Taking a look at some simple tips can help to not only start the planning for CECL, but to then take your model results and implement them in your business. The CECL results you produce can be invaluable for your institution in order to stay competitive in the marketplace and increase the profitability of your organization.

Most financial institutions have some knowledge about the new CECL standards, however, many FIs still have questions about the requirements, what to expect, how to begin preparing, and the difference between various CECL models. Here is what you need to know about CECL...

  1. Ensure Compliance – All organizations want to avoid regulatory scrutiny, so being compliant is a must. The real challenge that FIs have is what might be expected from regulators.
  1. Minimize Reserves – Most organizations want to minimize their reserve requirements. There is uncertainty and fear that reserves might increase by 30-50%, and for many organizations with low capital levels, this reassignment of capital to fund the reserves could create a situation where your organization is no longer well-capitalized. This is a real concern and could have significant impact on your organizations dividend policy and acquisition plans. The type of CECL model your FI selects is key to minimizing reserves.
  1. Provide Accurate Data – Model accuracy is a must. Having a compliant tool with minimized reserves is great, but you also want your model to accurately predict credit losses in changing economic times. The accuracy of the model is a key ingredient in your FI’s budgeting process. Additionally, as economic conditions change (as we saw in 2008/2009), we want our models to “predict” the losses based on new economic forecasts, so we can avoid some of the pitfalls experienced by organizations that failed during the great recession.
  1. Selecting a CECL Model – The FASB recommends using a variety of approved models to gain a clear insight on your potential credit losses. Using a variety of models provides a “second opinion” about your data.

In a recent study, various CECL modeling approaches were tested against mortgage data during the great recession. The purpose of this study was to provide tangible quantifiable results of how various models worked during this turbulent time. Below is a table that summarizes some of the key results related to accuracy and reserve requirements using various models.

Read the CECL study: Alternative, Impact, Accuracy and Complexity

The two clear winners in the accuracy question were vintage and discrete time survival model (a.k.a., advanced PD modeling). These had absolute error rates of 2.9% and 2.8% respectively. Other models were much less accurate in predicting results as illustrated below.

Vintage and survival models were also models that had low “forward looking” reserve rate forecasts as of January 2016 at .90% and .63%.

Based on this research, if you want accuracy and low reserves, these models provide the best results.

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5. Provide Results You Can Use – Forward-thinking organizations are already talking about how they intend to use CECL results within their organization. Institutions can use CECL results for budgeting, profitability analysis, pricing new transactions, and optimizing your loan portfolio. These strategic uses for CECL results allow you to reap the benefits of all your CECL efforts.

With CECL being an FASB standard, integrating CECL results into your existing financial management process is critical. Your institution should look at your CECL results at the account, product, and portfolio level and integrate those data points into your financial systems for budgeting, financial analysis, and pricing new transactions.

Making the most out of your CECL modeling efforts is key to the success of your FI, and starting the preparations sooner rather than later will ensure your compliant and profitable.

Topics: Financial Services Industry

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