If you have ever been to Miami, you know that it is known, among other things, for its pink flamingos. What you may not have known though is that there are more plastic flamingos in this country than real flamingos.
Before you fly away this morning, know that most community banks are beginning to peck away at the new Current Expected Credit Loss (CECL) rules. This is important because CECL could produce difficult choices, as it requires banks to compute expected losses over the life of a loan when the loan is originated.
When we surveyed community bankers about their CECL preparation, only 11% said they were ready. This could be due to the complexity of the rule, but also could be due to the different and possibly unfamiliar ways to calculate loss reserves. Under the rule, banks must choose from several methods and decide which ones work best for their various loan portfolios.
The key to preparing for and working with CECL is understanding how each method works. Then, take into account conditions and assumptions, which may change over the life of the loan. Community bankers must choose wisely and implement carefully to ensure reasonable and accurate estimates of loss.
In general, it is harder to model expected losses if a bank has very few losses overall. There simply may not be enough data to feed into models. That dilemma seems to fall disproportionately on community banks, which tend to be very good at making and managing loans and credits, so have few instances of high frequency of loss.
According to a polling question from the "Ask the Regulators" February 2018 CECL webinar, of the three methods shown, many bankers responded they expected to use two or more methods (41%) and 33% said they didn't know what they were going to use. The key takeaway is that there are a variety of ways to calculate your loss reserves, and that can be confusing when attempting to implement this new rule.
To assess methods, you might start by looking at your current approach. Then, review and discuss where your losses were, the loss amount, the number of losses and when they occurred.
Of course, optionality will also play into the discussion. What type of repayment structures do your loans have and what is the expected prepayment are questions to ask. Are they of similar repayment structures or do you have a collection of "deals" with differing repayment terms? If the latter is true, then optionality will be an especially important characteristic to consider.
Once you have done all of this, you will get a pretty good idea if your current loan loss method is the right one to use. You may find that it is the right one for some of your portfolios, but not for others. This is where it is important to test your methods with qualitative factors, such as interest rate changes, to ensure that your approach is solid.
When contemplating how to implement CECL, closely analyze each method against the loan portfolio. Then pick the correct method or combination of methods to yield the best results. If you need to better understand the methods, our webinar, Choosing the Best Methods for CECL: What's Best for My Bank, is available on demand. It provides an overview of the various methods, describes which ones are appropriate for different loan types, what data is needed to make good calculations, and how changes in economics and performance can affect the results.