With 2023 fast approaching and only six quarters remaining until the much-awaited CECL adoption date, smaller SEC filers and non-public banks are finding the standard’s conceptual nature a scary prospect. And given the unprecedented conditions banks are facing, it is crucial to define an allowance process that stands up to scrutiny and allows management to gain comfort over the allowance estimate. To accomplish these goals, banks must have a good allowance process that includes the following key components.
- A good reserve estimate is consistent and repeatable
A good estimation process should be end-to-end, streamlined, transparent and applicable across a variety of portfolios. The more manual an estimation process is, the more prone it is to unintentional change resulting in errors. And the more complicated a process is, the more cumbersome it is to execute and maintain. Independent processes can be prone to inconsistency, especially as they are updated over time. A complete and automated process will help address these challenges.
- A good reserve estimate starts with good data
It almost goes without saying that good reserving processes start with good data. Good data is clean, representative, validated and complete. Errors in data can stop the allowance process at a critical time. Data ought to be scrubbed to ensure that the process is seamless, reconciled and that the end result includes all of the bank’s in-scope instruments.
- A good reserve estimate is well-understood by management
A good allowance estimate needs to be right-sized for a bank. An overly simplistic process doesn’t allow management to have the necessary insight and may not be defensible. An overly complicated process and calculations are often not well-understood by management and may be burdensome and hard to manage. Management must understand the reserve estimate and the process used to generate it. This includes models used in the calculation and the key model limitations. Model limitations may be addressed through qualitative adjustments, but the adjustments and their impact must be well-understood. Read our "Qualitative adjustments under CECL – what are they?" blog post to learn more.
- A good reserve estimate is well-documented and validated
Good documentation around the allowance estimate helps ensure that the process is well thought out and builds comfort. Documentation should include information on the end-to-end process, model update procedures and key policy decisions around the reserve estimate.In particular, model calculations, limitations and their materiality assessment require thorough documentation. Management should also document how the bank will address these model limitations, as applicable.
- A good reserve estimate is transparent and includes reporting
A good reserve estimate is calculated at the loan level. The periodic cashflows, as well as adjustments on top of the contractual calculations (e.g., prepayments), should be known and available to management. The key components of the periodic loss estimate should be easily accessible as well as the impact of the macroeconomic forecast. Management and auditors should be able to select sample loans, calculate the expected reserve based on documentation and then recalculate the result, tracing the results to disclosures and provision entries.
Because CECL has so many moving pieces, reporting will be key. Management should recognize that reporting is a critical part of the CECL process and should be an important part of any comprehensive CECL solution. Stakeholders will require details of the reserve in a concise and transparent manner and only through a robust reporting process will a bank be able to address these expectations.
- A good reserve estimate involves a good process to evaluate results
A reserve estimate should have a process to evaluate its results. Outputs should align with management’s expectations of the future. Management should review what is predicted by the models to actual results over time, evaluate these differences and make adjustments to the process as necessary. Robust reporting can help in this process, as discussed.
- A good reserve estimate provides insight into a bank’s portfolio
Because CECL is a lifetime loss estimate that incorporates a forward-looking forecast, it provides management the ability to glean insight into the bank’s portfolio and sub-portfolios because it includes risk, finance, credit and economic data. As a result, many banks are leveraging their investment in the new reserving process to create better credit analytics, refine ALM processes and improve stress testing. These changes are allowing banks to then make better investment decisions.
While CECL is complex and creates challenges for banks, especially smaller banks, picking the right process can help address many of the key challenges they face and can be beneficial in many ways. To learn more about adjusting to the new CECL changes, download our "Qualitative Factors Under CECL" whitepaper or contact us.
Commercial Lending, Regulation