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Debunking CECL Myths for 2023 Adopters

This whitepaper will take the opportunity to debunk some of the misconceptions or myths in the market surrounding CECL. Our insights come from what we have seen from those institutions that have already adopted CECL as well our clients we are currently assisting with implementation. While there are likely more, we will focus on the top 9 myths we have come across in the last few years.

Introduction

As we begin 2022, many institutions have their eyes on the January 1, 2023 deadline for the adoption of ASC 326, commonly referred to as “CECL.” Since the initial adoption date of 1/1/2020, institutions that were SEC filers, excluding smaller reporting companies, have adopted CECL including those that were allowed a delayed adoption date of 1/1/2021 through the Cares Act. As of our 2021 Mid Year Review, this only accounted for 173 institutions whose stock traded on a Major Public Exchange and had total assets of less than $400 Billion. 

With this in mind, and despite several institutions expected to early adopt as of 1/1/2022, that is only a small portion of the banks in the US and leaves 15,000+ remaining institutions to stand-up CECL this year. While this standard has seen some twists, turns, and delays, the time is here for financial institutions to really focus on implementation efforts. 

This whitepaper will take the opportunity to debunk some of the misconceptions or myths in the market surrounding CECL. Our insights come from what we have seen from those institutions that have already adopted CECL as well our clients we are currently assisting with implementation. While there are likely more, we will focus on the top 9 myths we have come across in the last few years.

Myth 1

CECL will be the same for 2023 adopters as it was for 2020 adopters.

There are significant differences between the 173 banks we analyzed in our 2021 Mid Year Review that have already adopted CECL and the remaining institutions adopting in 2023. We took a look at the remaining banks with less than $20 Billion in asset size and found that 82% had assets less than $1 Billion and an average asset size of $759.3 Million. This compares to an average asset size of $23.6 Billion analyzed previously. So, what distinctions can we make between these two groups?

  • Technical resources – Many of the larger institutions had technical resources already in place such as data warehouses and data mining tools, in-house statistical models, and economic forecasting tools.
  • Human resources – Most of the larger institutions had, or could acquire/obtain, human resources that could be dedicated to CECL adoption such as model risk management, project management, credit, and accounting.
  • Financial resources – For those that did not have the technical or human resources in place, the larger institutions had the financial resources to invest in robust technology to build the teams to tackle CECL implementation or outsource to a third party vendor.

Taking all of this into account, many of the 2023 adopters are looking to third-party vendors to assist with their CECL implementation and determining how to use their limited resources most efficiently.

Myth 2

2023 is a year away, I have plenty of time to implement CECL.

While many institutions may be thinking they have a year to prepare for CECL and are putting off starting implementation, here are a few key reasons to begin the process now:

  • ParallelRuns – It is recommended that institutions complete at least two full parallel runs to include operational processes, approvals, and reporting. Allowing time for parallel runs as part of your implementation plan can provide great benefits including: 
    • Uncovers any errors in logic or assumptions.
    • Gives estimates of the impact upon adoption.
    • Provides an opportunity to test multiple scenarios. 
    • Evaluates sensitivity quarter over quarter. 
    • Tests internal controls framework. 
    • Allows for needed updates to documentation.
    • Supports model validation.
  • Model Validation – CECL model validation is increasingly being looked upon by examiners and auditors as a key item that documents the potential accuracy, reliability, and sufficiency of the CECL model. Ideally a model validation will be completed prior to adoption date and guidance suggests some form of validation be completed no less than annually.
  • Volume of 2023 Adopters – With over 15,000 institutions remaining to adopt CECL this year, there will be a significant push on resources whether it be third-party vendors, model validators, or the like. Waiting until later in the year could leave thousands of institutions fighting over the same resources needed to complete a CECL implementation.

Myth 3

You cannot use peer data for CECL.

One significant hurdle many institutions are facing when adopting CECL is obtaining accurate historical loss data. In order to capture loss data over a full economic cycle, banks would have to gather data back to 2007 and beyond. This is where peer or index data can prove beneficial and be a viable option until a more complete loss history has been compiled.

If an institution determines that it needs to use peer data to supplement, or in place of its own internal data, there are some key questions they must be able to answer:

  • Why does the institution have a need for external data? Document internal data limitations such as limited history and/or pool size.
  • Why is the external data source used appropriate for your institution? Consider documenting key characteristics of the external data source: # of banks included, average asset size, geographic footprint, etc.

Myth 4

Qualitative components of the allowance go away with CECL.

Qualitative factors have played a significant role in allowance calculations as they have provided means for management to consider factors that fail to show up in the quantitative portion of their calculation. As institutions have experienced historically low defaults and loan losses post- recession, we have seen a steady increase in reliance on qualitative factors over the last decade.

Additionally, pressure from auditors to provide support for qualitative factors or a perceived over-reliance had some hopeful that CECL would make a significant impact on how they were used going forward. However, the Interagency Policy on Allowance for Credit Losses confirmed that qualitative factors would still be considered under CECL: “Historical credit losses generally do not, by themselves, form a sufficient basis to determine the appropriate level for ACLs. Management should consider the need to qualitatively adjust expected credit loss estimates for losses not already captured in the loss estimation process.”

This became even more evident during the COVID-19 pandemic as the 2020 adopters were faced with unprecedented economic times while simultaneously adopting CECL. Most institutions relied on qualitative adjustments to capture unknown risk in the portfolio that the quantitative portion failed to capture.

Myth 5

You can just use Call Report data for CECL.

As some institutions are overwhelmed with the anticipated complexity that comes with adopting CECL, they have been looking for simpler methodologies using easily accessible data such as call report data.The Fed’s recently released SCALE (Scaled CECL Allowance for Losses Estimated) method has been deemed acceptable for use by banks less than $1 billion in assets and leverages peer call report data.

While at the surface, these simplistic methodologies may seem appealing they aren’t without their challenges to consider:

  • Peer loss rates are the starting point and, in many cases, may not be as accurate as a bank’s own historical losses. Qualitative adjustments would be required to appropriately capture that adjustment for the unique risk of the bank.
  • While individually assessed loans can be tracked within the SCALE tool, separate worksheets will need to be maintained for the detailed impairment calculations.
  • Qualitative adjustments can be input within the model; however, determination and documentation of those adjustments will need to be maintained outside of the model. Consideration will also need to be given to the fact that qualitative adjustments are already included in the peer calculation, but will face immediate challenges as details on peer qualitative adjustments are not readily available.
  • An overall adjustment can be made to the peer group lifetime loss rate based on the difference between the peer group and institution experience; however, this is calculated on the portfolio as a whole. It may be appropriate for banks to consider an analysis on individual loan segments versus the whole portfolio.
  • Banks that are acquisitive or approaching the $1 billion threshold would need to develop an alternative methodology in order to be in compliance once the threshold is crossed. Banks should also note that the threshold and compliance requirements do not differ by geographical region.

Myth 6

CECL takes months to implement.

As noted above, institutions are looking for more simplistic ways to implement CECL and may be overwhelmed by the perceived amount of resources and time needed to implement. In reality, the time to implement doesn’t have to take months and can be streamlined in an effort to move to parallel runs sooner and limit the strain on resources. An expedited approach can be achieved by having a few key elements in place:

  • Good current loan data. If you have the ability to pull some key data elements of your existing loan trial such as balance, maturity date, call code, payment structure, and risk grade you may be able to apply peer or index loss rates to your portfolio.
  • Acceptance of use of index data. Much of the time spent in CECL implementation is spent on gathering historical data. If you are comfortable that the index data accurately represents the risk in your portfolio and any adjustments can be made through qualitative factors, you can skip the step of gathering tons of historical data. Meanwhile, you can begin building your own historical data on a go forward basis.
  • Decision on reasonable and supportable forecast. Whether you intend to use forecasting tools in the quantitative portion of the calculation or simply utilize qualitative adjustments, a quick decision on method of forecasting will expedite the implementation process.Direction for qualitative factors. Determining what changes you intend to make to your existing qualitative factor framework for the transition from ILM to CECL is critical to adoption but can be a fairly straight forward process to work through.

Myth 7

Explaining CECL to the board is easy.

Explaining CECL to your board is an important part of the governance and oversight of the CECL implementation; however, it may prove to be one of the most difficult ones. While you may be “living” CECL day in and day out, your board has oversight responsibilities for the entire institution’s operations and may find the new standard and its associated terminology difficult to understand. Below are some best practices on how to most effectively communicate to the board:

  • When? The simplest answer is early and often.If you haven’t started having CECL discussions with your board, start NOW. As with any difficult concept, the more you hear it, the more it begins to click. Repetition is key and with time, your board will be able to effectively communicate with examiners and investors about CECL and your implementation efforts.
  • What? It is critical to not give information overload when discussing a topic as complex as CECL. Begin with an overview of the standard and some of the basic concepts such as life of loan, reasonable and supportable forecast, and the prevalent methodologies. Then focus on your implementation plan, key deadlines, and expected financial impact.
  • How? Provide written summaries and presentations that your board can go back and review after your meetings. Again, they are likely absorbing a lot of information for various operations across the organization at once and will appreciate the ability to go back and spend more time with your presentation materials.

Myth 8

Once CECL is implemented, it won’t change.

CECL is not a set it and forget it type of adoption. Due to its robust nature many factors could cause institutions to revisit their calculations and assumptions. These factors could be both internal and external in nature. For example, a newly acquired portfolio may require a fresh view of methodology or even an entirely different methodology than the rest of the portfolio. A major environmental change could require different segmentation and the need to analyze specific portfolios that could be impacted. A prime case study in this was the COVID-19 pandemic and its impact on the 2020 adopters.

Institutions were geared to adopt CECL in the first quarter of 2020 under a very stable economic environment, and then everything changed. With expected record high unemployment and GDP contractions, forecasts were revisited with most institutions looking to some form of stressed forecast scenario. Specific portfolios were facing grave challenges, such as the retail and tourism industry, forcing management to take a closer look and further stress these portfolios. Multiple government stimulus packages led to stability in the market; however, many were unsure how and if this should be represented in their CECL models.

Ultimately, the pandemic brought about model adjustments and a significant increase in reserves of 82bps in the first two quarters of adoption as seen in the chart below.

Myth 9

You can wait until CECL is implemented to start your documentation.

While it may be tempting to wait until your CECL implementation is complete to begin documentation, be mindful of exactly how detailed and extensive the project is. Documenting everything along the way will help you prepare for model validation, auditors, and examiners. Begin with gathering documentation related to any meetings you are having with management, external consultants/advisors, and the board such as agendas and minutes. Maintain documentation for any training sessions management attends as auditors and examiners will want to know that management has a good understanding of the CECL requirements and their own internal model. You will also want to specifically document key decisions made during implementation. Some of the most common are as follows:

  • CECL Committee – Document responsibilities and members. Who has oversight over the CECL Committee?
  • Third Party Advisor & Software – Are you planning to engage a third-party vendor? If so, document the vendor selection process.
  • Data – What data sources will you use? What time period does your data cover? What Critical Data Elements (CDEs) will be required for the CECL Model? Document any data gaps or decisions around how much historical data you will be using.
  • Segments & Classes – How will your aggregate your loans on the basis of similar risk characteristics? If your segments and classes differ from your current ILM, why?
  • Loss Methodology & Selection – Which loss methodology did you select? Consider documenting pros and cons of each potential methodology you contemplate.
  • Use of External Data – Are you having to use external data? Document why you are relying on external vs. internal data and why the external data source is appropriate for your institution.
  • Forecasts & Reversions – What period of time are you using for your Reasonable & Supportable forecast? What is your source for your forecast? What period of time and method are you using for reversion?
  • Qualitative Factors – What qualitative factors are you carrying over from your existing ALLL model? Ensure you are not double counting anything already captured.
  • Model Documentation – Ensure you have a thorough model document that covers the technical aspects of the model such as model development, theory, assumptions, and limitations.

Final Notes

With 2022 underway, there is work to be done to prepare the remaining 15,000+ institutions for CECL adoption. Dispelling these myths should go a long way in assisting as they begin their CECL journey. With many looking for a third-party partner to assist on their implementation journey, Valuant is here to help with our excellent software solution and first-class advisory services.

About the Author

Shannon Morrison, Managing Director of Consulting

Shannon has almost 20 years of experience in the banking industry with a specialty in accounting and financial reporting. Shannon has managed the ALLL process and led the implementation of CECL at a variety of financial institutions on the ValuCast platform. Shannon has accounting and management experience at banks up to $21 billion in total assets. At Valuant, Shannon specializes in CECL readiness and implementation and advisory services. In addition, she is responsible for the internal training and development programs for the Client Service Team. Shannon obtained her MBA from the University of South Carolina. She attended the Graduate School of Financial Management and Bank Investments at the University of South Carolina, the SC Bankers School in Columbia, SC, and the AIB Principals of Banking in Hartsville, SC. Shannon obtained her BBA from Furman University. In addition, Shannon is a Certified Government Finance Officer.

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As part of an annual study that began in 2020, Valuant conducts analysis on ASC 326, commonly referred to as “CECL”. The study contains key data statistics and insights around the US Regional and Community Banking sectors and the impact CECL has on their Allowance for Credit Loss (ACL) Coverage Ratios.

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