Understanding CECL Validation: A Comprehensive Guide for Financial Institutions
The Current Expected Credit Loss (CECL) accounting standard has ushered in a new era for financial institutions, transforming how they calculate their allowance for credit losses. This shift from the old incurred loss model to CECL requires institutions to estimate future losses over the life of a loan, rather than estimating inherent losses at the balance sheet date. While CECL aims to provide a more accurate picture of potential loan losses, its implementation comes with challenges, particularly for smaller financial institutions.
Understanding the Transition
Under the incurred loss model, banks estimated loan losses based on past events and information available at the balance sheet date. However, CECL demands a forward-looking approach, where institutions must forecast future losses based on current economic conditions and historical trends. This change requires a more individualized and dynamic calculation process, breaking away from the previous one-size-fits-all mentality. Additionally, the losses for each loan should theoretically be recorded at the time the loan is originated.
Importance of CECL Validation
Auditors and regulators expect institutions to provide thorough documentation and justification for any changes made to the model or its inputs. The CECL validation will provide a granular review of the data inputs, judgments made by management, and the overall technical compliance and conceptual soundness of an institution’s CECL calculation.
Key Judgements Reviewed during a CECL Validation
Qualitative Factors
CECL requires institutions to assess qualitative factors, such as changes in lending staff, delinquencies, and non-accrual loans, compared to the look back period for each loan segment. Any deterioration in these factors demands a higher loss factor adjustment, necessitating a meticulous quarterly review process.
Economic Forecasts
Economic forecasts play a pivotal role in CECL calculations. Institutions must regularly update their forecasts to reflect changing economic conditions, ensuring that their estimates remain relevant and accurate. Additionally, the forecasts should be prepared in a way that ensures the institution can perform back testing at a future date.
Individual Loan Reviews
CECL requires individual credit loss reviews for loans that do not meet the risk characteristics of any of the loan segments. These individually reviewed loans should include loans (1) that have no significant chance of incurring a loss (ie. have U.S. Government guarantees or are well-secured by liquid collateral that is assigned to the institution) and (2) collateral-dependent and non-accrual loans, to determine their risk profile and potential losses. Having a robust, consistent approach to identify the loans for individual credit loss review is critical and differs from the impaired loans under the incurred loss method.
Documentation and Governance
Thorough documentation of assumptions and methodologies is crucial for CECL compliance. Institutions must also ensure that their governance structure involves key decision-makers, such as the senior lending officer, CFO, or CEO, in approving significant changes to the model. Additionally, documentation is expected to be retained to support how back testing and other learning throughout the institution’s CECL journey are incorporated into current and future calculations.
Educating Boards and Decision-Makers
Many boards and decision-makers lack a deep understanding of CECL, which can hinder effective governance and oversight. Institutions should consider educating their boards to ensure they grasp the complexities and implications of CECL, enabling them to ask management critical questions regarding the significant judgements included within the CECL calculation and make informed decisions.
CECL validation is a critical process that demands a shift towards a more individualized and dynamic approach to loan loss provisioning. By understanding the key components of CECL and ensuring thorough documentation and governance, institutions can navigate the challenges of CECL effectively, ensuring compliance and accurate reporting.
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This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
