What Lenders Need to Know About CECL

The End Of the Educated Guess

This is the first of a mulit-part blog series on what lenders need to know about CECL. We will discuss how CECL is different from historic loss analysis, how your business needs to adjust, and what you can do now to ensure your business remains compliant and competitive.

CECL Is Driving Banks to Transform Data Into Intelligence

For about forty years, lenders have measured losses from impaired loans based on historic annualized charge-off rates. That approach captures events that have already happened, such as regional economic downturns, but it fails to help banks make informed decisions about future risks.

CECL replaces incurred-loss models based on annual loss rates with expected-loss models based on life of loan loss rates. The significant difference is that while incurred-loss models show losses, expected-loss models forecast risk.

The Digital Crystal Ball

Forecasting risk is tricky without a crystal ball. However, we have the next-best thing: data. CECL will require lenders to create detailed Allowance for Loan and Lease Losses (ALLL) pools based on the ages of loans (vintage), terms of loans (actual life of loan), and loss accumulation periods (relative position on the loss curve).

Loans of different ages and seasonings behave differently, so separate estimates have to be developed to address each vintage by loan age in each future year; for example, if a portfolio has an expected life of four years, four years of losses have to be projected for loans originated in 2017 (year one), three years for those originated in 2016 (year two), two for those originated in 2014 (year three), and one for those originated in 2013 (year four).

These projections must be made for each asset and risk rating pool, and justifiable macro and local economic projections have to be applied as well. There are also other ways to calculate CECL, such as creating a probability of default and loss given default for the life of each loan, although these are more likely to be employed by larger lenders who have the data and manpower to perform them. In the next blog we will talk about how we can better know the future off of past data.

For a more indepth look into the upcoming CECL regulatory changes, download our CECL guide below.

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