FAQ 2: Impact of CECL
The Impact of CECL for Financial Institutions

Boxer Hitting Heavy Bag
CECL is a complex accounting rule. You will likely run across obstacles along the way. These FAQs can help you.

CECL requires that financial institutions 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.

Financial institutions that hold loans (and securities) with maturities beyond the next year or two will be particularly affected by CECL. 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.

For real estate loan calculations, financial institutions will need to look at a number of different factors to create an accurate life of loan. Specifically, they will need to use their historic data to determine historical prepayment rates. To properly value optionality embedded in the life of loan, many will need to break them into distinct coupon 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 methods under CECL work best. Additionally, real estate and other loans with balloon payments will likely need to be separately grouped as balloons may alter both prepayment as well as default/loss expectations.

Financial institutions need to start to prepare for CECL today. The first step that PCBB helps institutions with as part of its comprehensive solution is assessing their historical data and determining what data they need and what data they do not need. Organizations also need to get multiple departments involved in the CECL preparation. It can't be left to one department, individual or piece of software alone.

Although implementation of CECL is about two years away for many financial institutions, the time to start preparations is now. Financial institutions are preparing to be CECL-compliant, which means they need to collect the appropriate data, select the appropriate models test assumptions robustly and create comprehensive documentation. Financial Institutions need to consider the type of data that they will need to make a lifetime loss estimate. Many financial institutions may not have collected and stored the type of information and data that may be necessary to perform the loss and life of loan analysis required for the CECL models.

Everyone should use this interim time until implementation to review these changes with external auditors and regulators, as they prepare for implementation. It is important to consider the type of modeling methodologies that might be appropriate for different loan portfolio types as well as the data requirements for the different methods. This includes reviewing accounting and servicing systems across multiple departments to determine whether the institution is able to capture the necessary data for CECL's implementation. Getting an early start is particularly important if the institution will need to adjust data collection practices, modify its internal controls, or update its IT systems to prepare for implementation.

There will be a substantial amount of work required during the interim period before implementation. Specifically, the following steps should be completed:

  • 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 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
  • Vet findings with management, board, auditor and examiners
  • Run parallel until cutover

Time requirements for CECL will be more than your current process as you will need to integrate the life of loan component into the measurement as well as adding an overlay for the forward look component. The amount of additional time will vary depending on the complexity of the portfolios [longer dated and structured loans (balloons) will require additional time versus shorter term fully amortizing loans]. Additionally, if HTM securities are present, they will need to be valued as well for both default/loss risk as well as any embedded optionality (prepayments, call, puts and other structures).

Financial institutions need to involve numerous departments from the C-level down to risk and compliance. Typically, individuals involved will come from the following areas:

  • Credit: CCO and loan operations
  • Finance: CFO and controller
  • IT: CIO and DBA's

Additional CECL FAQs

  1. The What, When and Whys of CECL Implementation
  2. The Optimal CECL Approach for Financial Institutions

Additional CECL Resources