Navigating the CECL framework: 10 key takeaways for financial institutions

For many banks, the transition from the “incurred loss” model to the more forward-looking Current Expected Credit Losses (CECL) framework continues to present significant challenges. A pattern of common issues has emerged as institutions navigate the ongoing application of CECL methodologies. These issues include outdated policies and records, skewed data and inaccurate forecasts. 

Here are 10 actionable takeaways to help institutions address key areas of concern and strengthen their CECL methodologies.

1. Choose your peer group wisely

Regularly update peer group selections to reflect accurate and active peers. Outdated or irrelevant peer selections can skew modeling and undermine credibility. 

For example, avoid using peers that are no longer in operation or differ significantly in asset size, as these can distort the accuracy of your analysis.

2. Refine collateral selling cost estimates

Make sure assumptions regarding selling costs are clearly documented and have supporting data. This includes breaking down components such as brokers’ fees, holding costs, and any other relevant expenses. 

Analyze selling costs, taking various factors into consideration such as the nature of the collateral, the bank’s past experiences, market conditions, and any other relevant variables.

3. Segment loan portfolios strategically

You should segment loans into pools based on similar risk characteristics. Also provide a clear and documented rationale for portfolio segmentation criteria. 

The resulting segments should be detailed and statistically meaningful to reflect the unique characteristics of the assets. Avoid creating segments that are too small, such as those consisting of one loan.

4. Strengthen control processes and address deficiencies

When it comes to processes such as data reconciliation and manual adjustments, separation of duties and oversight is crucial to maintaining accuracy and reducing risks. 

Centralized control by a single individual, without an independent review or approval process, presents a substantial risk to the accuracy of the ACL calculations and the reliability of the financial statements at large.

5. Keep policies and records current

Make sure all policies and documentation reflect current accounting standards, avoiding outdated references to the incurred loss methodology. 

References to the “incurred loss” methodology: (1) ASC 450-20, (2) ASC 310-10, and (3) ASC 310-30 should not be documented in credit policies or other documentation as the impairment models have been replaced by ASU 2016-13 (Topic 326).

6. Provide analytical support for models 

Confirm that the selection of economic factors and any changes in the weights assigned to these factors within the ACL model are clearly supported. Whenever possible, model the impact of these factors on the bank’s portfolio to better understand how economic conditions may influence credit risk and loan performance. This approach helps ensure that the model accurately reflects potential risks under varying economic scenarios. 

Example: If rising insurance premiums are a factor considered in the model, demonstrate how an increase in insurance costs would affect debt service coverage. For example, a 10% increase in insurance premiums could be modeled to show how it impacts the ability of certain borrowers to meet debt obligations, potentially leading to defaults or breaches in loan covenants.

7. Reinforce board oversight

The results of the ACL model must be presented to the board of directors or a board committee for review and approval. The meeting minutes should document a comprehensive discussion, critical evaluation, and approval of the reserve allocation determined by the model. These minutes serve as evidence that the board exercised proper oversight and made a well-informed decision. 

The meeting minutes should illustrate a robust discussion, including challenges to the results, assumptions or individually analyzed loans. There should be clear approval of reserve allocation, including any adjustments made to the model’s results at the meeting.  

8. Conduct stress testing 

Conducting formal stress testing to assess the potential impact of adverse economic conditions or extreme events on the balance sheet is vital for effective Asset/Liability management (ALM). 

Stress testing can assess capital adequacy by predicting potential credit losses and their impact on reserves and ultimately earnings and capital. This would aid in capital planning by identifying challenges that may arise during an economic shock.  

9. Analyze and calibrate models regularly

Conducting outcome analysis and periodically calibrating ACL models are essential for making sure the models provide reasonable and actionable insights to support decision-making.  

Comparing model results to actual outcomes helps confirm the model’s accuracy or highlight areas where adjustments may be necessary for improved simulation. While minor tweaks are typically made throughout the year, a formal validation is crucial to ensure the model continues to perform effectively. 

10. Leverage historical loss data effectively

Historical loss data, such as charge-offs, recoveries, and delinquencies, is essential for calculating expected credit losses. Using incomplete or inappropriate data can result in unreliable model outputs. 

Historical losses serve as a crucial benchmark for the ACL model, forming the foundation for estimating expected losses. If an institution relies on a historical period dominated by either an economic boom or downturn, the data may be skewed, leading to inaccurate forecasts with reduced predictive value. 

Sustaining CECL success: A collaborative effort 

The ACL model is akin to an athlete striving for peak performance—it requires continuous training, learning, and adaptation. Achieving optimal results depends on the collaboration among individuals across various roles within the organization to ensure the model operates effectively and the outcomes are accurately reported. With the right procedures in place, you can not only avoid negative audit findings but also prevent unforeseen liquidity or capital challenges. 

If you’d like to learn more about CECL and how these guidelines may impact your financial institution, contact us or another member of Kaufman Rossin’s Risk Advisory Services consulting team.