2. sageworksanalyst.com
1
I N T R O D U C T I O N
The Financial Accounting Standards Board (FASB) voted
5–2 on April 27th
to move forward with the proposed
Accounting Standards Update, Subtopic 326-20, more
commonly known as the current expected credit loss
(CECL) model. The final standard, expected to be passed
in June 2016, will require institutions to reserve against
losses on loans when they originate or acquire them and
to re-estimate losses on an ongoing basis. The move to
a CECL model is a departure from current GAAP, which
requires institutions to defer the recognition of a credit
loss until the loss is “probable and estimable,” or has
been incurred. The change is in direct response to the
most recent global financial crisis. 1
In the draft standard and subsequent Transition
Resource Group (TRG) meetings, FASB members were
intentionally non-prescriptive regarding acceptable
methodologies available to institutions performing
their quantitative loss calculations under the CECL
standard. Board member Lawrence W. Smith reiterated
the non-prescriptive nature, saying, “We are not
prescribing specific methods of doing the allowance
at all.” 2
(1:33:50) Instead, the FASB listed examples of
CECL-compliant calculations in their draft, including
vintage analysis and the historical loss rate approach.
Institutions will be free to use their judgment when
developing estimation techniques as long as they are
consistently applied over time and aim to faithfully
estimate an actual life of loan loss. 3
H I S T O R I C A L L O S S M E T H O D O L O G Y
M I S C O N C E P T I O N S
A misconception may have created a false sense of
CECL readiness for some institutions. The notion that
an institution will be CECL-compliant by utilizing
a historical loss rate methodology extended from a
current model is inconsistent with the requirements of
a forward-looking model and will not yield a calculation
that faithfully estimates an actual, life-of-loan loss at a
portfolio or asset level. By nature the “expected loss,” or
forward-looking element of the new standard, changes
the application of the current “incurred loss” annualized
historical loss rate methodology.
Many groups, including the Independent Community
Bankers Association (ICBA), lauded the inclusion of
the historical loss rate approach as an acceptable
methodology for the quantitative portion of the CECL
w h i t e pa p e r
CECL Historical Loss Misconceptions
allowance calculation.4
The inclusion of a historical loss
example has led to some confusion, such as historical
loss under CECL being indicative of a buildup of annual
historical loss rates rather than a specific portfolio’s
cumulative loss experience. 5
Others have interpreted
the inclusion of historical loss to allow a continuation of
their current methodology. 6
TRG member Doug Wright spoke specifically to the first
misinterpretation:
...some institutions may look at this and
basically take an annual loss rate and
accumulate that over ten years and come
up with their allowance based on that.
That completely ignores the life of the asset.
Without considering or interjecting something
around the life of the asset, I think there is a
danger of an over-simplification that results
in a reserve rate that is not reflective of what
should be in there. 7,8
(1:41:50)
Additionally, board member Thomas Linsmeier added,
“We have to get people to stop thinking this is a build-
up of annual loss rates.” 9
(1:48:14) Russell Golden, FASB
Chairman, said, “What some people have thought is that
when we’re looking for a ten year loss rate, which is not
what we ever intended, was that you could aggregate
ten annual loss rates. This would obviously grossly
inflate the reserve.” 10
(1:50:00)
Some in the industry are grappling with the draft
example, which provided an a priori loss rate, presumably
calculated under a static (or cohort) migration approach;
where the forward looking losses of specific assets are
divided by the beginning balance of those same specific
assets to obtain a rate. This example does not use the
average historical loss rate methodology common in
an incurred loss model, in which the annual losses are
simply divided by an average balance.
The devil for bankers will be in the details. If a bank
or credit union elects to utilize a traditional historical
loss rate methodology (charge-offs/average balance),
determining how to adjust an average historical loss rate
to become forward-looking and inclusive of prepayments
may prove to be difficult. 11
3. sageworksanalyst.com
Figure 2, below, provides the distribution of the
absolute reserve calculations under each methodology.
It should be noted that static migration analysis
was chosen arbitrarily; there is no “best analysis” for
any portfolio segment, nor the broader portfolio
in its entirety. We chose a static migration analysis
for our example using loan-level data and applied
it consistently to arrive at a loss rate for the period
under consideration. The most appropriate analysis
will depend upon an institution’s goals, the risks
and co-performance characteristics of a segment,
and reliability of data available. Not only should
institutions consider several forms of analysis, they
should also consider and evaluate several different
approaches to portfolio segmentation.
One can quickly see how negatively impactful to an
institution’s capital simple aggregation of historical loss
averages can be when used as a basis for calculating
expected loss. While the static migration approach
inherently incorporates prepayments and correctly
only considers the portfolio that exists at the beginning
of the analysis period, the accumulation of average
historical loss rates ignores declining prepayments and
includes losses attributable to loans that did not exist
as of the beginning of the analysis period: two dramatic
and material differences.
As pointed out above, it is important to reiterate
that these calculations reflect the historical loss
experience only and do not account for forward-looking
adjustments based on estimates of the economic cycle
relative to the loss experience. These forward-looking
adjustments are significant because the position in
an economic cycle, and other qualitative factors will
continue to be important factors impacting results
under CECL guidance.12
2
M E A S U R I N G T H E I M PAC T W I T H R E A L
B A N K DATA
To illustrate the distinction between such
interpretations, Sageworks selected twenty-eight real
data sets of banks comprising institutions with more
than $100MM in loans and less than $1B. The loan
parameters were chosen to be reflective of common
sizes in the community bank market, and the sample
was limited to 28 banks in order to include only
institutions with loan-level data ranging back to 2010.
These institutions were idealized as a single portfolio
segment, and a life-of-loan assumption of five years
was made. Two credit loss estimation methods were
applied. First, a cumulative five-year average historical
loss rate method commonly confused with the approach
shown in the CECL ballot draft; second, a simple static
migration-to-loss rate for the portfolio balance over
the same period. Qualitative adjustments were
not considered.
The specific rates calculated are not meant to be
extrapolated to any given institution; rather, the
objective of this analysis was to compare the “simple”
historical loss approach to other approaches that begin
with the same model assumptions.
The change in reserve requirements was measured
for each bank. Figure 1 illustrates the distribution
of institutions experiencing a given reserve impact
under this model. A number such as “16%–30%” should
be interpreted to signify “use of the noncompliant
cumulative historical loss method calculates historical
reserves between 16 and 30% higher than the migration
method.” This exercise does not attempt to measure
reserve requirements against an institution’s existing
incurred loss model.
w h i t e pa p e r
CECL Historical Loss Misconceptions
Cumulative
Migration
.76 1.45 2.39 5.13 10.76
0 .85 1.94 3.41 7.57
0 1 2 3 4 5 6 7 8 9 10 11
Reserve Percentage
4. sageworksanalyst.com
N E X T S T E P S F O R YO U R I N S T I T U T I O N
Based on info from the TRG and time to adoption, the
only significant changes to the final CECL draft (set to
be released in June) will likely center around whether
or not the draft reflects the objectives of the guidance.
As Lawrence W. Smith indicated at the beginning of the
April 1, 2016 TRG meeting, “We do not want to get into
a debate regarding the decisions the board has made;
those decisions have been made... let’s just focus on the
decisions that have been made and whether the draft
reflects those decisions.” 13
(6:50)
Given the CECL model is due out soon, management at
banks and credit unions should pursue the following
next steps:
1 | Forecast and evaluate the calculated
reserves utilizing various methodologies
The Board has been clear that different methodologies
will yield different results. They have also been clear
that the PCAOB, AICPA, SEC and bank regulators are
comfortable with this reality. Therefore, understand
how a particular approach will impact capital and
reserve levels at the institution. 14
(7:30) Including
information obtained by stressing the portfolio and
any assumptions in an institution’s calculations will be
critical to gaining even greater understanding.
2 | Determine the platform by which you will
perform the calculations
Understanding which platform provides the ability
to perform the above calculations with an effective
allocation of resources is nearly as critical, and
could be determinative, of an institution’s chosen
methodology. Some institutions will deploy some of
their most valuable resources and personnel to execute
the aforementioned items. Some will elect to reserve
the same resources for a more strategic approach in
analyzing and interpreting the results. Additionally,
use of in-house developed models will likely preclude
many institutions from exploring different approaches
to the calculation due to lack of flexibility common in
Excel models.
3
3 | Consider the long-term data
storage implications
Management should consider the costs and logistics
of ensuring that adequate data storage maintains its
integrity and is accessible and secure. Not only does
this pertain to the data required for the calculation,
but the results of the calculations themselves. Some
may find it difficult to have multiple historical ranges
by which to calculate some of their long-range assets’
historical loss experience. If adequate loan-level
detail dating back to 2010 is stored, an institution is
just now accumulating enough history to quantify
loss experiences for 5 and 6 year-lived assets. Ideally,
institutions can use the historical loss experience
that most adequately reflects the institution’s current
situation. Many institutions will not know what data
to store until they begin performing calculations
and simulations.
4 | Leverage the results
These considerations and conclusions can be extremely
valuable provided the results are accessible and
incorporated into a strategic plan. Management can
use the calculation as a tool to gain insight into
their portfolios and create synergies across multiple
responsibility centers within the institution.
By being proactive and considering the aforementioned
items now, institutions can take advantage of the
additional transition year given by the FASB and ensure
that they have fully vetted the many methodologies at
their disposal. The goal is to end with a documented
and defensible calculation that optimizes capital
impact and accurately reflects management’s true
expectation regarding expected losses specific to their
respective portfolios. Solely relying on an average
historical loss rate methodology without understanding
the true implications severely limits an institution’s
understanding and flexibility in capital planning and
proactively maintaining reserve levels.
w h i t e pa p e r
CECL Historical Loss Misconceptions
5. sageworksanalyst.com
A B O U T T H E AU T H O R S
Neekis Hammond is a senior risk management
consultant at Sageworks. He provides financial
institutions with advisory services, leads thought
leadership, develops market strategies and consults
with product development on solution requirements
and accuracy.
He specializes in the ALLL; CECL preparation
and methodology; acquired loan accounting and
valuation — ASC 310-20, ASC 310-30, and ASC 820; stress
testing, and various portfolio analysis topics — PD, LGD,
migration, vintage, prepayment, utilization, pricing, risk
rating, etc. Neekis has also facilitated multiple FDIC
Assisted Acquisitions. Prior to joining Sageworks, he held
a key role within Elliott Davis Decosimo’s FIG Consulting
division, where he provided valuation, accounting, and
loan analysis services. Preceding Elliott Davis Decosimo,
he was with a multi-billion dollar financial institution,
where he worked on acquisitions ranging in size from
$130MM to $2 billion, and worked as an auditor with a
regional CPA firm.
Neekis Hammond
Senior Risk Management Consultant
4
w h i t e pa p e r
CECL Historical Loss Misconceptions
A B O U T S AG E W O R K S
Sageworks (www.sageworks.com) is a financial
information company working with financial
institutions, accountants and private-company
executives across North America to collect and
interpret financial information. Thousands of bankers
rely on Sageworks’ credit risk management solutions to
streamline credit analysis, risk rating, portfolio stress
testing, loan administration and ALLL calculation.
Sageworks is also an industry thought leader, regularly
publishing whitepapers and hosting webinars on topics
important to bankers.
Sageworks ALLL is the premiere automated solution
for estimating a financial institution’s reserve. It helps
bankers automate their ALLL process and increase
consistency in their methodology, making it defensible
to auditors and examiners. Sageworks’ risk management
consultants also assist clients with the implementation
of their ALLL models and guidance interpretation.
To find out more, visit www.sageworksanalyst.com.
Brandon Russell
Account Executive
Brandon Russell is an Account Executive in the Risk
Management Solutions group at Sageworks, where he
is primarily focused on helping community banks and
credit unions manage their allowance for loan and lease
losses (ALLL) provisions. Prior to joining Sageworks,
Brandon served in various business development roles
at startup companies Attentive.ly and Management
C.V., as well as Ipreo, a financial information, data, and
software company serving corporate investor relations,
private capital markets, and the institutional buy-side
and sell-side. He received his master’s degree from
Georgetown University and his undergraduate degree
from George Mason University.
6. sageworksanalyst.com
E N D N O T E S
1
Tysiac, Ken. (2016). Journal of Accountancy, FASB to draft final standard on credit losses.
http://www.journalofaccountancy.com/news/2016/apr/fasb-votes-to-issue-credit-loss-standard-201614335.html
2
Meeting with the FASB Transition Resource Group for Credit Losses. Audio Webcast. Friday, April 1st, 2016.
https://m.youtube.com/watch?v=EBTC7jA4jwo
3
Financial Accounting Standards Board—Financial Instruments—Credit Losses, Measurement of Credit Losses on Financial
Instruments, Transition Resource group (TRG) Meeting, April 1, 2016. Subtopic 326-20-30-3 and 326-20-30-5.
http://www.fasb.org/cs/BlobServer?blobkey=id&blobnocache=true&blobwhere=1175833233419&blobheader=application%2Fpdf&blobhe
adername2=Content-Length&blobheadername1=Content-Disposition&blobheadervalue2=733760&blobheadervalue1=filename%3Dcred
it-loss-TRG-meeting-handout-20160401.pdf&blobcol=urldata&blobtable=MungoBlobs
4
Independent Community Bankers Association (ICBA). Press Release. Wednesday, April 27, 2016.
http://www.icba.org/news/newsreleasedetail.cfm?ItemNumber=603428
5
Same as cite 3. Subtopic 326-20-55-20-22.
6
Haynie, Ron. (2016). Independent Banker, FASB Revises CECL Standard for Community Banks.
http://independentbanker.org/2016/04/fasb-revises-cecl-standard-for-community-banks/
7
Same as cite 3. Subtopic 326-20-55-20.
8
Same as cite 2
9
Same as cite 2
10
Same as cite 2
11
Same as cite 3. Subtopic 326-20-30-6.
12
American Bankers Association, January 2016. Current Expected Credit Loss model (CECL) and FASB’s Community Bank Roundtable.
http://www.aba.com/Issues/Index/Documents/CECL-backgrounder.pdf
13
Same as cite 2
14
Same as cite 2
5
w h i t e pa p e r
CECL Historical Loss Misconceptions
