CECL FAQs

Current Expected Credit Loss is the accounting standard introduced by the Financial Accounting Standards Board (FASB). CECL changes how financial institutions estimate and account for credit losses on financial assets, primarily loans and HTML securities. CECL requires financial institutions to record “life of loan” loss estimates at origination or purchase. This replaced the Incurred Loss (ICL) accounting model.

CECL eliminates the requirement to defer the recognition of credit losses until a loss is probable; consequently, applying this model will result in earlier loss recognition. CECL took effect on January 1, 2020 for public financial institutions registered with the SEC, and January 1, 2023 for all other institutions.

FASB, including various stakeholders, determined that the Incurred Loss standard delays the recognition of credit losses and overstates assets, especially in the last global economic crisis. This standard does not recognize a loss until it is determined that it is both probable and predictable. This process limits the loss estimate to current, objective evidence and ignores future expected events. As a result, incurred loss estimates serve more as a lagging indicator of impairment losses rather than a leading indicator of expected asset performance.

According to Federal banking regulators, CECL not only affects how financial institutions calculate credit loss reserves, but also how they fundamentally model their losses and organizational processes for both finance and risk management.

The scope of these changes is substantial and depends on the complexity of the institution’s balance sheet. CECL requires a much deeper level of modeling, analysis and reporting than what was previously required. These are significant changes for financial institutions, as they gathered complete financial data, built analytic platforms and shared information between departments.

Community based financial institutions, with a focus on real estate finance, need to do additional work with respect to loans that lack highly similar repayment characteristics (CRE and Multifamily versus Single Family). Many times, commercial real estate transactions are referred to as deals versus loans which would be an indication that they lack similar repayment characteristics, and thus will need to use component versus loss rate methods.

While some institutions may consider shortening the terms of their loans to minimize some of the repayment complexities of their loans under CECL, rollover risk and default risk could increase with shorter term loans.

White Paper: Loan Maturity and CECL: The Balance Between Rollover Risk and Reserves

CECL requires financial institutions to record “life of loan” loss estimate for unimpaired loans at origination or purchase. This replaces the current “incurred loss” accounting model, and it poses significant compliance and operational challenges.

Many community banks hold large allocations of assets with longer maturity dates - usually arising from real estate loans. This adds to the complexity of the calculation. For example, since real estate loans have maturities of 10-30 years, and borrowers often want the ability to pay off or refinance these loans early, this prepayment optionality must be included in valuing the loan life.

White Paper: CECL Challenges: Prepayments and Diversification

For real estate loan calculations, financial institutions look at a number of different factors to create an accurate life of loan. Specifically, they use their historic data to determine historical prepayment rates. To properly value optionality embedded in the life of loan, many need to break them into distinct loan groups to most accurately measure optionality (just like they do when they measure interest rate risk).

The challenge facing financial institutions is both gathering and analyzing this data and determining how many similar groups should be modeled and which CECL methods work best for these groups. Additionally, real estate and other loans with balloon payments likely need to be separately grouped as balloons may alter both prepayment as well as default/loss expectations.

Under the CECL rule, financial institutions can choose from several methods and decide which ones work best for their various loan portfolios. Since many financial institutions have more than one loan type in their portfolio, they will likely need more than one method.

Since there are a variety of ways to calculate your loss reserves, selecting the method can be confusing. For example, it is harder to model expected losses, if you have very few losses overall. There simply may not be enough data to feed into the model. That dilemma seems to fall disproportionately on community financial institutions, which tend to be very good at managing loans and credits, so they have few instances of high frequency of loss.

To make it a little easier, PCBB FIT Advisors work with our clients to advise them as much or as little, during CECL implementation, on which method works.

On-Demand Webinar: Choosing the Best Methods for CECL: What’s Right for My Bank?

FASB have stated that the Weighted Average Remaining Maturity (WARM) method is acceptable for some financial institutions to perform their CECL calculations. This method calculates an annual expected charge-off rate, based on multiple historical periods. It then takes that rate and applies it to the remaining balances of assets in a given group times the WARM. While FASB noted that this method could be used for less complex financial asset pools, bankers will need to explore the consequences when using WARM.

Q Factors are meant to compensate for adjustments needed due to changes that occur outside the model, including: global economic trends; business conditions; the nature and volume of loan terms or portfolio; concentrations of credit, among others. When working with Q Factors, your institution always has control and makes the final decisions.

On-Demand Webinar: New Expectations for Q Factors with CECL

Forward Look refers to the reasonable and supportable forecast required in CECL. This is your estimate of how much immediate future losses may differ from historical losses.

There is a substantial amount of work required to use CECL. But after you have implemented it, it should become part of your process. Here are a few steps to note as you build “muscle memory” for this activity:

• Inventory available data inputs
• Analyze data (repayment terms, default and loss history, changes in underwriting and grading, etc.)
• Determine workarounds for missing loss history vs. asset life
• Identify similar loan groups and check to see if sufficient information is available to use
• Test each method (do the calculation) to understand data requirements and determine if the method produces meaningful results
• Choose methods for each similar group by its unique characteristics
• Generate results including sensitivity analysis around key assumptions (prepays, migration, rising/falling past-due/non-accrual)
• Determine the financial impact of the method(s) used
• Continue to vet findings with management, board, auditor and examiners

Auditors are responsible for evaluating the reasonableness of an institution’s implementation of CECL, ensuring it aligns with the prescribed accounting standards, and confirming that it provides a fair and accurate representation of the entity’s credit risk.

They play a crucial role in assessing a financial institution’s compliance with accounting standards, including CECL. When auditing an entity’s implementation of CECL, auditors may inquire about various aspects to ensure compliance and accuracy. Some common questions auditors may ask regarding CECL include:

• Methodology and Assumptions: the rationale behind the assumption, the models used, and the consideration of forward-looking information.
• Data Quality and Validation: the quality and accuracy of the data utilized in the credit loss estimation process. They may examine how the data is gathered, validated, and what controls are in place to ensure its accuracy.
• Management’s Expertise and Oversite: the level of involvement and oversight by management and oversight in developing and implementing the CECL model. This involves assessing the expertise and competency of the individuals responsible for the estimation process.
• Documentation and Disclosure: reviewing the documentation supporting the CECL estimates and related disclosures in the financial statements. They may scrutinize the adequacy and transparency of the information presented to stakeholders.
• Sensitivity Analysis and Scenario Testing: exploring how the estimates would change under different economic scenarios to assess the robustness of the CECL model.
• Changes and Updates: explanations and the reasoning behind any changes in the methodologies or assumptions.
• Internal Controls and Processes: assessing the internal controls and processes established by the institution for the CECL estimation. They may ask about the policies, procedures, and monitoring mechanisms in place.

PCBB provides an integrated, web-based solution to financial institutions, combined with banking experts that will advise as much or as little as you need. PCBB’s solution, CECL FIT ™, provides results for multiple methods, allowing financial institutions to move seamlessly to alternative methods when conditions warrant.

Learn more: View CECL FIT

PCBB provides institutions with the ability to move their data and information to a flexible platform that is independent from the core system. This platform permits the calculation of time series analysis necessary for both loss rate under the multiple methods as well as historical prepayment rates, which are necessary to determine life of asset. Additionally, this platform supports other complex analyses needed for both qualitative factors and the Forward Look.

We have spoken to many institutions that want to do CECL in-house. It is possible, but we find that the complexity and understanding the consequences leads many to ask PCBB for help and choose a lower tier of the solution.

Hear from Chief Credit Officer, Michael Kerr of First Federal Bank who shares his experience with CECL, and why his institution ultimately decided to outsource CECL, after starting off in-house.

Learn more: CECL Case Study: From In-House to Outsourced (Micro-cast)

Yes. PCBB has a Statement of Controls (SOC) for our existing data center and has an additional SOC for our proprietary applications, of which CECL is included. These address the controls for all of our production environments, including access and data.

CECL FIT™ lets you select one, two or more CECL methods. Test different methods to discover the most suitable one(s) for your institution. We can advise you on which methods are best suited for your loan portfolio groupings. We offer the following methods:

• WARM
• Static pool
• Vintage analysis
• Average charge-off
• Roll-rate (Migration)
• Probability of default (PD)
• Discounted cash flow
• Regression analysis

This allows financial organizations, with PCBB’s assistance, to mix and match these different methods for various portfolio segments to determine the optimal result. Additionally, this flexibility permits a seamless transition from one method to another, as economic conditions warrant.

Learn more: CECL FIT in Action

Yes. CECL FIT accommodates Held to Maturity Securities (HTM Securities). They can be grouped and assigned a loss rating, as well as generate an expected credit loss value for the period.

PCBB’s advisory team of financial service professionals works with institutions to help them determine the optimal roadmap for CECL.

The steps include:

• analyzing the information to determine proper portfolio segmentations;
• testing various CECL methods to determine which methods best match each portfolio’s segmentation;
• generating results and determining financial impact, if any;
• vetting findings with management, the board, auditor, and examiners, along with creating comprehensive documentation.

Yes. Each institution is unique. So, PCBB created three tiers of CECL FIT to best meet your institution’s specific portfolio needs and budget. Each of our options provides a balanced range of services, depending on the requirements you need.

Plus, we offer our Right FIT Promise that allows you to start with one level today but you can change to a different tier, if your needs change.

Learn more: 3 Tiers of CECL FIT to Meet Your Needs