Over the past 20 years I’ve experienced the usual ups and downs of home ownership. A leaky roof, a flooded basement, as well as the two-week bathroom remodel that turned into an eight-week job. I’ve seen it all. At first, I tried to tackle many home projects on my own. I soon discovered that I was a pretty good painter and a really bad plumber. After I accidentally caused an upstairs toilet to leak into the family room ceiling, I resolved to get help from a trusted plumber that had the proper tools and know-how to get any plumbing job done right.
For those of you who are in the process of implementing the new CECL accounting standard, who is your trusted plumber? Is it you? If so, here are some of the issues you’ll need to address.
Smaller and less complex institutions may use the same segmentation practices as the incurred loss method. For many smaller institutions, this may mean segmentation by Federal Call Code. The problem is that there may not be enough individual loans to create a statistically significant sample size for each segment. If your institution’s historical loss data is insufficient due to sample size, or if you haven’t had many losses in general, peer data can prove invaluable to fill in the missing gaps.
If you’re the plumber: What effort will it take to periodically pull in peer data for my internal model? What if you’d like to compare multiple peer groups? How will you incorporate that data based on the segmentation that you chose?
If hiring a plumber: Many third-party providers are able to supply peer data where statistical significance is lacking. Look for third parties who are able to incorporate that peer data into the segmentation you have chosen.
Creating a Forecast
Regulatory guidance dictates that all institutions must create a forecast. While it may not be required that the forecast cover the entire life of the asset, it is strongly suggested.
If you’re the plumber: Have a system for gathering cash flow estimates for your model. You may need to take cash flow estimates from your core or ALM model and adjust for the segmentation present in your CECL modeling. (Good luck if the data isn’t granular enough or is too granular!) Make sure you have the ability to include potential prepayments.
If you hire a plumber: Obtain cash flow and prepayment data using the same segmentation as your CECL modeling. Look for an easy way to compare the new CECL results back to the incurred loss method results.
Accounting for Economic Changes
Additional guidance on this issue is forthcoming, but there is an expectation that economic factors are considered when forecasting loss estimates.
If you’re the plumber: Where will you get a suitable, defendable economic forecast? And if you have a forecast, how will you apply this forecast specifically to your future loss estimates? The St. Louis Fed has a treasure trove of data one can use, but you may need a doctorate in statistics to incorporate this data into your modeling.
If you hire a plumber: Many third-party models automatically incorporate economic data into the model forecasting.
Money Versus Time
Plumbers can be expensive, but who has the time to do their own plumbing projects these days?
Let’s face it. Your personnel and monetary resources are not limitless. At some point a decision to do it yourself has to be made from a cost/benefit standpoint.
If you’re the plumber: Model development and maintenance will require a time commitment. When the requirements change, how will you keep up with these changes? Is your data gathering process a manual one? Ensuring data accuracy (yes, there will be an audit) requires effort. Will there be a model validation requirement? Excel formulas get broken.
If you hire a plumber: The model will already be developed and should be maintained. Data gathering should be somewhat, if not fully, automated (if not, what’s the point?).
Regulatory agencies agree that there is no single ‘correct’ CECL methodology you should apply. The key to an effective CECL implementation will be to develop an estimation method that will be applied consistently, be documented, and use the principles of the new accounting standard. If you choose to do it yourself, just make sure that you have insurance.