CECL Blog Series – Part #2
This blog was authored by my colleagues, Tanya Medgaarden, a principal in our financial institutions practice in Southern Minnesota and Michelle Cinciripino, a director in our financial institutions practice in Dallas, Texas.
Welcome back to the CLA CECL Blog Series. As a reminder, over the next several weeks, CLA will take a deep dive into many of the hot topics surrounding the Current Expected Credit Loss (CECL) standard. In this blog, we’ll discuss some important determinations institutions need to make when building their CECL model. Don’t forget – on October 28, 2021, CLA will host a webinar designed to answer any remaining questions you may have. Make sure you receive our invitations by signing up for CLA communications here. We hope you find great value in this blog series and welcome the interaction with any of the authors.
Loan Segments
A portfolio segment under the CECL standard is defined as the level at which an entity develops and documents a systematic methodology to determine its allowance for credit losses. The standard also discusses the balance between having too much aggregation of the portfolio and overburdening the financial statements with excessive detail. Appropriate segmentation would involve combining loans with similar risk characteristics. Examples of portfolio segments could include, but is not limited to:
- Type of financing receivable
- Industry sector of the borrower
- Risk rating
A class of financing receivable is identified by disaggregating a portfolio segment to the level the entity uses when assessing and monitoring the risk and performance of the portfolio. Examples to consider may include, but are not limited to:
- Categorization of borrowers
- Type of financing receivable
- Industry sector
- Type of collateral
- Geographic distribution
Credit quality indicators should also be considered for each class of financing receivable. Credit quality indicators are judgmentally selected for each class of financing receivables. Examples of credit quality indicators may include, but are not limited to:
- Consumer credit risk scores
- Credit-rating-agency scores
- An entity’s internal credit risk grades
- Debt-to-value ratios
- Collateral type
- Collection experience
- Other internal metrics
The loan segments used under CECL may end up being the same or similar as those used under the incurred loss model. However, consideration needs to be given to the factors discussed above when determining the appropriate segmentation under CECL. When determining segments, institutions should note that data availability, as well as data integrity, will play a significant role in which factors can be used to segment the loan portfolio. If a data element cannot be relied upon as accurate, the institution should take steps to improve its internal controls over the data element or consider excluding it from the calculation.
Lookback Periods
The CECL standard discusses that historical information generally provides a basis for an entity’s assessment of expected credit losses and an entity may use historical periods that represent management’s expectations for future credit losses.
There are situations where having availability of that type and quantity of information is not possible (such as new loan products, long-lived loan pools where that amount of history is not available, etc.). In these circumstances, more judgment will need to be used to determine expected credit losses. This may include using other outside information such as peer data. Using the actual historical data of an institution is a good starting point. Over time, the historical periods the institution has to evaluate will continue to grow.
Lines of Credit and Credit Cards
Evaluating risks and a historical period for an open-end loan such as a line of credit can be different from other closed-end loans due to the revolving balance and no set maturity date of the loan. It is important for a financial institution to estimate the remaining life, amount, and timing of payments on a line of credit. It is also relevant for a financial institution to evaluate the users of their credit cards to determine if they are a revolver or a transactor. A user that typically carries a balance over from one month to the next is considered a revolver. A user that typically pays off their balance every month is considered a transactor.
The determination between revolver and transactor can be helpful in evaluating whether the loan segment has a risk of default and how profitable the segment will be. A financial institution may see that revolvers take a long time to make payments or pay off balances which would impact the life, average balance, and estimated payments on the loan, which in turn may increase the inherent risk of lifetime losses. This information alongside the other credit quality indicators mentioned above, can be helpful in estimating the life of the loan and determining the risks in this loan segment.
How can we help?
Regardless of where your institution is at on your CECL journey, CLA is prepared to assist your institution in any way we can. Throughout this blog series or at any time, contact us with your questions. We look forward to being a resource for your institution as you navigate the implementation process!
Joshua Juergensen is a principal with CLA. He works with banks and credit unions nationwide, managing audit engagements, directors’ exams, external loan file reviews, internal audits, and other consulting services.
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