CECL – Beyond Implementation, Part 2

Virginia Robbins (00:06): Welcome back to banking out Loud. I'm Virginia Robbins, your host. In our last episode, we spoke with Andy Hines about his experience with CECL, and specifically about data. Andy Hines (00:16): You get it set up correctly on the data side. As that data goes in, then it's a functional tool for everybody in the bank. And CECL's just one part of it, a LM. Everything else kind of feeds off of it. Virginia Robbins (00:28): You don't need to have listened to that episode to follow today's conversation. But he offered a lot of useful information based on the data needed for CECL. So if you haven't already, I recommend checking it out. In this episode, our conversation on CECL with Andy continues We'll discuss his experience getting started with CECL and how his exposure and participation prepared his institution for CECL. Andy will also tell us what he feels a spreadsheet approach may not be right for most institutions. Let's dive in. Virginia Robbins (00:58): So, Andy, what was the journey that your career took from where you are and and where you are today? Andy Hines (01:04): Once I had gone back for graduate studies and then, you know, it seemed the appropriate time to leave active duty, I joined at the time they were called Sunbank, but they later became SunTrust, of course. And they, they hired me because of what they believed to be the value I could add to their corporate banking effort on defense. I was sort of the defense guy for a number of years. There was a lot of consolidation in the nineties. Mm-Hmm. . I had all the, you know, big defense companies where we had leading banking relationships. I had other Fortune 100 type companies in my portfolio. We did a tremendous amount of synthetic risk rating at the time, using models that are employed by the debt ratings agencies. 'cause at that point, when we were applying this type of data analytics or predictive analytics, it was so that we would appropriately price deals so we could take them to the market and so on. (02:06): Mm-Hmm. and transitioned over to community banking. And the whole time in community banking, I've done basically what I do now. Small banks will sometimes call it the chief Credit Officer. Sometimes it's the chief lending officer. Most small institutions, you're kind of the combined role and you're responsible for intellectually certainly how you set these systems up. You're creating them, supporting 'em, validating them, and adapting to change, you know, as the regulatory environment changes. And there has been a terrific amount of change that all of us in this business, you know, have had to adapt to. I was with a correspondent bank in the Mid-Atlantic for a while, which was a lot of fun because we banked a whole collection of smaller regional financial institutions. And that was one of the best in my career, because again, in your banking career, it's, you get really isolated. (03:04): You're, you, you don't get a lot of feedback about best practice across other institutions. Well, there I also became the president of our loan review function. So, and it was during the great recession, so I really got to see a lot of s spillt milk and work with a lot of people that were struggling through the great recession. Saw a lot of regulatory commentary. It was very informative. And the allowance for credit losses has just changed every few years since the nineties. And then it, you know, really hit community banks from about 2005 through 2008. And it was a hard transition for many to make. For whatever reason. I just kind of continued to enjoy the challenge of it, digesting it and then figuring out how to move through it, creating policy and procedure and, and so on. Virginia Robbins (04:00): All the good stuff. So, you know, Andy, you've made the transition from the Navy to large banking, to small banking, uh, to, to community banking from, you know, large institutions to small institutions. And now we're talking about another transition that's going on from incurred loss to CECL. And, you know, there's a lot of aspects of this that we could talk about, but the, you know, the, the, one of the things, uh, that comes down behind all of this is at the end of the day, CECL is attempting to help banks create an adequate provision. So when you look at the challenges that a small bank faces, uh, in ensuring that they have an adequate precision, uh, provision, what are the things that come to mind for you? Andy Hines (04:42): Well, the change that we're going through right now, the transition to what hopefully will be a, a better methodology for setting aside reserves for potential losses has been a long time coming, you know, rolling into the great Recession. There were so many banks that I would help when I was at the correspondent bank and, and doing consulting work and advisory, that I would hear the same thing all the time. Well, we don't have reserves 'cause we haven't had loss history. Mm-Hmm. . And of course the environment was changing rapidly. And where there was deterioration, um, oftentimes the point at which they were trying to put those reserves aside was the same point at which loan growth and yields on the loan portfolio were down. So you had this perfect storm of now being pushed to set money aside, and yet at the same time, that's not your strongest period in earnings. (05:44): And, you know, those of us that have professionally been involved with it and have participated in regulator panels and everything, yeah, we all get it. But there are a lot of challenges. You know, if you get real conservative about saying, I really think, you know, we need to set money aside, it's difficult because you may recall in the late nineties, especially with the bigger banks and the bigger bank I worked for back then, there was this criticism of putting too many reserves aside on a rainy day just so you would be covered. Which seems ironic, but, you know, you'd think that's exactly what you wanna do. But if you're not careful, and especially in larger corporations, there seems to be a conflict of interest with managed managing earnings. Mm-Hmm. . So you really, you really stuck. You, you know, you understand the expectations, but at the same time, you're being tugged in another direction. (06:34): So you've got a lot of stakeholders that each have their own point of view. What I mm-Hmm. . So we keep evolving, we move away from that kind of model where, what used to be just the quality of your risk rating system, and then slight, slight amounts of reserves for every loan in the portfolio to aggregating pools, looking at loss history and putting reserves aside based on your historical losses. And then having to beef that up somehow if you haven't had any losses in those portfolios. But even that, of course, was kind of inadequate. And, you know, the wheels started turning on CECL, boy, boy, I'd have to go and look back. But, but during the great recession, basically, right? Mm-Hmm. . And, you know, we've been in these working groups with, with accounting professionals and other lenders providing feedback and commentary for all those different periods where FASB or the regulators were asking. (07:32): I feel that the approach is totally appropriate. Now, if, if you can forecast what should be required in the way of reserves when you put that loan on the books, and it's a combination of things that goes into it to co to get to that number. But of course, it's gotten immensely more complicated to arrive at that number. And so, I know I've given a lot of information, but to answer your question about like, what is the challenge? Well, the challenge is supporting all of the kinds of assumptions you have to make in order to build up that analysis. Very complicated. It's not the same thing as just being accurate with your loss history, segregating portfolios, applying that. It's now that and more. And the complexity of performing the analysis and supporting it is a gigantic challenge for smaller institutions where, you know, one or two individuals really have to carry that process. (08:39): But it's entirely consistent with this trend that has occurred in the modeling that's now being done for both liquidity and sensitivity in banks. So there's this shift to these black boxes that are outside the bank. And vendors of course, because they're the only ones that really can have that kind of competency in their organizations because they're looking at larger data sets. They have powerful analytic tools, and they use them frequently. So you're not gonna get a bunch of errors creeping in there because someone like me essentially has to go through a learning process every time I touch the black box. And we've seen the same thing on fair lending analysis and, and so on. There, there's no way you can just do it on a spreadsheet anymore. And so a big challenge because of the complexity and then a big challenge because you're thinking in your head, oh, how am I gonna communicate this? Support it to everyone's satisfaction. Virginia Robbins (09:37): So it's, it's actually in some cases, not so much like with scale or warmth, the the details of the math, but what's implied in the assumptions behind the math, and how do you make sure that your accountant or your accounting firm understands that your regulator understands that your board understands that. And, uh, for those of us who have shareholders, uh, shareholders understand that. 'cause it, as you say, it's, it's always a trade off between safety and sometimes bottom line numbers as well. Andy Hines (10:06): Yeah. You know, and then there's this legacy that goes back, you know, to the late nineties. I remember when we were employing, um, you know, various models that, you know, there's always this embedded sort of potential conflict of interest. It's a complex analysis. You have to do it, you have to make assumptions. And then what is your interest in the whole thing, more or less it is easily, you know, we use modeling to mark to market the assets, the, the investment assets in the bank, but we use significant amount of modeling now to effectively mark to market the loan assets. So you're talking about very material judgments or estimates that are made that have a huge material impact on earnings. Mm-Hmm. . And, you know, for the big banks that transitioned last year, for people who are, you know, have the kind of strange interest that I do, you know, in these types of topics, we watched the early implementation by the largest financial institutions, and it was during a time that was topsy-turvy, of course. Mm-Hmm. . And then of course you're seeing it as appears in the press about, you know, reserves being taken back, you know, negative reserve provisions, which is Mm-Hmm. , which is substantially from the very positive provision that occurred because of the nature of CECL. Right. So they always think, you know, that to your point in managing communication, yeah. You gotta do it just right, because everybody assumes that everyone has their point of view on it. And of course, at the end of the day, that kind of comes down to the impact on earnings. Right. Virginia Robbins (11:47): You know, one of the things that we've seen in, in talking to folks between incurred loss and CECL is the concept of, you know, that it, it used to all be about, as you mentioned before, about grade or about something that I could easily point to for my board member. So my reserve went up or down perhaps, uh, in relate to the volume I've added, but more usually greatly because of a grade change and grade changes were often controlled by management in some way, shape, or form. So it seemed like the process was more controllable in many ways by management, perhaps. And now we're moving to, I mean, CECL involves the life of the loan, the volume that you've put on the life of new originations. It involves many more factors, your loss history, the assumptions in your loss history, what your forecast is for the future. So when you sit down and parse that out, Andy, as someone who's spoken to their board and to their stakeholders, how did you help them understand the differences between incurred loss and CECL? Andy Hines (12:50): Well, it is very difficult for people to understand this concept of what I call a, a kind of a cost of lending. So cost of lending isn't just the cost to originate the loan, which many institutions are able to defer over the life of the loan and so on. Things we're familiar with from Gap, the cost of lending is upfront now where we have to take a number when we close that, you know, and set it aside right away for potential losses in the future, as opposed to where we were just before that, which is, well, we haven't had many losses, and therefore the only impact that would happen is as the loan volume increased, you'd apply the same metric again. And so one of the most confusing things for people to understand about the new methodology is that you're looking at, like you do in an a LM analysis, you're looking at your future portfolio and the balances within the portfolio, assuming you don't make any more loans, you know, so mm-Hmm, , this is the payment of the loan. (14:03): So next year I have a hundred dollars, the following year it's gonna be $80, and then it'll be 60 until it matures and it's gone. And in each one of those years, we're now forecasting a loss factor that gets applied in each year, which is built up from history, from comparison with peers. And then it's applied in every one of these periods going forward. And then that stream of cash flows is brought back to the present, and you've got a number. And that number divided by that current loan portfolio gives you another loss factor. And it's very confusing for people to really kind of fully understand. Traditionally they're used to seeing a loss factor, and they know that was based on your loss history plus whatever little mod adjustments you wanted to make. Now they, they have the most difficult time reconciling, okay, well I see this number and you divide it by the total portfolio, you get, you know, this percentage, how I don't understand. (15:00): And you know, it's this stream of cash flows that goes out into the future. And the other thing that's really, you know, counterintuitive for people is, for example, traditionally you might have a portfolio that's large and it's a consumer portfolio. It's had its share of losses and tr and, and historically you had a lot of reserves there, but it's a portfolio where the loans pay off in 18 months or two years. Mm-Hmm. . So what happens when you make this transition, it's not all like uphill With CECL, you might have had a million dollars against that portfolio in the older model, and now you only have $450,000 and you're, and people are challenged to kind of explain how is this possible? This just doesn't seem, you know, it's very counterintuitive whenever you're, you know, got big changes like that. It really, it gets a lot of attention from everybody and you, and you're challenged to explain, well we're, we're putting reserves against the future losses. (15:55): And you have to understand this portfolio pays off in no time flat. Conversely, if you have a residential portfolio where you're holding 30 year mortgages, your loss history might be really low. You know, you've never really had any problems with residential mortgages. You know, they're homeowners, it's a great area. Your loss history is like 15 basis points and everybody's used to that. But when, if those loans really stay on the books that long, it's probably still somewhere around 15 basis points. But now you gotta look 30 years into the future Mm-Hmm. In each one of those periods, bring it back to the present and it's just knocking people's socks off . You know Virginia Robbins (16:31): What I mean? It's, it's different. It's, it's just different, right. In terms of you've gotta fix, it's very different. Yeah. It's very different. Andy Hines (16:38): Yeah. Yeah. People are like, I don't understand this. This is the safest portfolio we've had. We've never had those kinds of, why is it all of a sudden we have to, because you go, well, you know, the average life of that portfolio is 25 years. And a lot can happen in that time. And you know, you that's, you know, you don't get a lot of happy feedback on stuff like that . Virginia Robbins (16:59): So that's, that's for your board and your stakeholders and, and running through it with, uh, that Now when you talk with your accountants, do you find that the accountants understand cil or are they also still trying to sort of wrap their heads around it? Andy Hines (17:14): Well, you know, there was an accounting firm that I work with from the beginning. It's a big national firm, very large in our metro DC area here. But they have offices all across the country. And they really took in their business, they engaged a lot and they engaged for probably business development purposes. And they helped me understand a lot about it. Right. They had experts and so on. And, and then you can get into much smaller firms that might only have one or two customers in their financial practice, partially because of consolidation in smaller banks. And there's still lot of smaller companies that provide the external audit for small non-public financial institutions. Mm-Hmm. . And it's kind of like, you know, if you've got a complex surgery, go to the hospital where the doctor, you know, they crank out like, you know, they do a hundred a week. (18:06): I mean, I'm, I think they figured it out , you know what I mean? And they have a lot of confidence. And if you're gonna be at a very small rural hospital where maybe the doctor has only seen one in the last couple years, there's greater risk, I think. Yeah. So that's challenging. I know over time they will learn more from our process. I know that there's gonna be a very great reliance upon, because we've already seen this with the models we use in liquidity and sensitivity, and to an extent in the analysis of our investment assets, there's a terrific amount of reliance by the external auditor placed on the third party, you know, big five type auditor of the vendor. Mm-Hmm. for the reliability and fidelity of their model. Right. And then if that's taken care of, and you know, you've got your SOC reports and all that Mm-Hmm. , those are the chief concerns you would have to address with them. And then you get the other types of concerns, which is they wanna make sure that the internal controls and other things are correct. And if you design a good internal audit process, then they're gonna rely heavily on that as well. And then it should knit together. But I think those are the sensitivities Virginia Robbins (19:19): And the important part is, uh, no matter who your auditor is, engage with them early so that you can understand where, where their strengths and weaknesses are, what questions they're asking, what's important to them. And to make sure that when you get to that point where they're actually auditing this, there's fewer surprises. Yeah. How, yeah. When working with the regulators, have you found the discussion, we've, you know, over time we have seen at times regulators and accountants take different positions on reserves. How have you seen the discussions with regulators towards CECL? Andy Hines (19:52): So, so far they've, even during the process of preparation for CECL mm-Hmm. , and I believe it was in a fill a number of years ago, financial institutions letter. And they basically laid out to banks what they believe should be the appropriate roadmap to CECL implementation. And I know I used this, I used it in, you know, advising to others and sharing with other professionals like myself, you know, organize yourself around those recommendations. 'cause they are familiar with that. And so that was during the long implementation process because they were concerned about risks associated with you being prepared to make the transition on whatever deadlines. And it applies to different institutions. They might be, I recall that in the small financial institution, when the regulatory community became much more engaged on a LM analysis and sensitivity and so on, that, you know, initially we had to make transitions to black box type models and where the confidence develops, and this is just something everybody has to understand. (21:04): You make reasonable kind of assumptions about it going in, but it'll be a multi-year process as you back test the assumptions in those models. And then eventually there's, you know, there's a, a, a confidence that's developed by, uh, all stakeholders, but it takes time. Nobody is just gonna come right out of the blocks, you know, a hundred percent confident. And I, I, that's okay. You know, it's, it's not a, because I've seen how this works with other types of, you know, bank modeling and it has a lot to do with your process, your awareness that that's how it's gonna work. Mm-Hmm. in the end, you know, it probably will be better because, you know, there's a whole nother side of people like me in these small companies that's terrified by these, you know, 20 tab Excel spreadsheets that are your own black box model that just, you know, they're just too error prone. (21:58): Companies have been trying, once they invest so much into that Excel spreadsheet, you know, we, we went through the turn of the century, so we're in the, the aughts and then you're trying to drag along your methodologies in the 2005 to 2008 timeframe. The call reports changing once more detail. And, and you, you know, you get wedded to these internal models that you use and data collection and, and it's actually very non adaptable. You know, if you have to build systems mindful of how it's going to continue to change and evolve, um, mm-hmm, and even this will, I'll guarantee you. Virginia Robbins (22:40): Thank you for tuning into today's episode. For more information about CECL, visit pbb.com/products/CECL. You can watch and listen to all of our podcast episodes on our banking out loud webpage at pcbb.com/podcast.