Simplifying CECL Compliance Amid a Pandemic

Given everything else going on in fiscal 2020, (Covid-19, a recession, the election, protests in the streets, wildfires, etc.), it might be understandable that executives of community financial institutions almost completely forget about CECL.  However, certain of these events may significantly impact the credit quality of loan portfolios and heighten the need to better understand the consequences of these events on loss reserves whether measured under either existing or future accounting guidelines.

With the CECL accounting standard already implemented by most of the largest US financial institutions (nearly 80% of all commercial bank loan balances are currently accounted for under CECL), community bank directors, shareholders and investors are continuing to ask…“what is the impact of CECL on the capital position of the bank?”

Despite the noise caused by the current chaotic environment, there are two relatively simple actions executives of community financial institutions can take to effectively answer this question.

First, if you haven’t already done so, complete a parallel CECL analysis alongside your most recent quarterly ALLL to determine a preliminary impact of CECL on your current capital position.

Secondly, since we know that changes to an institutions economic forecast can have outsized influence on the level of additional reserves required, conducting a loan and capital stress test will help to determine the full range of possibilities for further erosion of a bank’s capital position, should economic events unfold in a more unfavorable manner than currently expected.

These two actions, taken together, will put you and your institution in a very good position to answer all of the relevant questions that your audit firm, regulators, directors, shareholders and investors are currently asking of you, and will continue asking until these questions have been adequately answered.

Simplifying the CECL Analysis

Regulatory expectations regarding CECL compliance has clearly stated for some time that smaller institutions (total assets < $10 Billion) with “non-complex” loan portfolios, (this included most institutions), are not, or at least will not initially be, required to implement CECL models that employ advanced loss estimation methodologies, such as Migration Analysis, Discounted Cash Flow, PD/LGD, etc.).  In other words, simplified loss estimation methodologies, such as the WARM method (Weighted Average Remaining Maturity), are likely acceptable for most smaller institutions.

If your institution has had trouble getting started with CECL because of either a real or perceived inability to support a robust CECL model including advanced methodologies, we strongly recommend that you implement a simplified CECL model first.  Essentially, this is a “walk before you run” strategy which gets you solid preliminary estimates of your CECL impact today, which you can refine and enhance in the future, as you assemble more complete loss estimation databases, and as your analytical capabilities grow.

A good start on the development of a perfectly acceptable, simplified CECL model, would include just the following elements:

• Pool segmentation at the Federal Call Report Loan Code level;
• Incorporation of a Weighted Average Life (WAL) estimate coordinated with you current Asset / Liability model, which includes bank specific prepayment assumptions;
• Use of recent historical loss rates by product type, looking back a period of time consistent with the lives of your various loan pool segments (typically 1 – 5 years);
• Qualitative Adjustment factors, similar in format to your current ALLL QA factors, but modified to reflect the difference in look back periods (i.e. life of loan vs. annual);
• Adjustments up or down to the overall estimate, based on management’s baseline economic forecast.

A beginning simplified CECL model utilizing the five steps described above represent only a slight modification of your current ALLL process but results in a very good estimate of your eventual financial statement impacts from CECL.

Loan & Capital Stress Testing

Using the results of the above described simplified CECL loss estimation model as a starting point, stressing the economic forecast for a variety of alternative unemployment rate levels (a commonly used economic statistic with high direct correlation to industry Net Charge-off rates) provides a range of estimates for increasing loss rates, and potential decreases in capital.  Assessing these alternative loss and capital impacts provides of simulation of potential future results and allows the bank to put contingency plans in place as well as developing well thought out and reasonable capital plans.

Assistance, As Needed

The recommendations above represent sound financial management / best practices in the areas of CECL and loan and capital stress testing for community financial institutions appropriate for this current point in time.  Some institutions may have already implemented these systems at a best practices level, and other institutions may have the capabilities of implementing these recommendations with currently existing internal resources and will implement successfully in the coming months / years.  It is likely however, that most community based financial institutions have not, cannot or will struggle to implement these systems on their own in the near future.

FORVIS provides community based financial institutions with assistance in the area of implementing CECL through its’ proprietary software, CECLAdvisorPRO®, and through the provision of customized consulting assistance based on the unique needs of individual clients.  In particular, FORVIS provides a CECL solution which meets the simplified implementation approach described in this article which we call the Enhanced Historical Loss Rate Method, which is both effective and efficient in enabling entry level CECL compliance, as described above.  For clients that require more advanced CECL loss estimation methodologies, or wish to develop more complex models, a full implementation of our CECLAdvisorPRO® solution is available.

FORVIS also provides a comprehensive stress testing report that leverages the methodology and framework utilized by the regulatory agencies in their capital assessment programs and as referenced in regulatory guidance, and which is consistent with loss estimation methodologies that will be required under CECL.

If you would like to discuss any of the topics addressed above, or wish to have a personalized demonstration of FORVIS CECLAdvisorPRO® solution, please feel free to contact either Jeff Morris (jmorris@probank.com) or Andy Morgan (amorgan@probank.com).