With the Right Approach, CECL Implementation Could Mean Current Expected Credit Profit
From the moment it takes effect in 2020 and beyond, CECL will change how your financial institution operates.
The new accounting standard, which requires you to calculate the expected loss over the life of each loan and set aside reserves to cover those losses at origination, will impact how your financial institution views and manages risk.
Gain a clearer view of risk with data
With CECL, financial institutions must determine the potential credit loss over the life of the loan once that loan is originated. This is challenging because various economic factors, such as rising interest rates or higher unemployment rates, can affect borrowers’ ability to pay, thereby impacting the quality of a loan portfolio.
When the credit quality of a loan portfolio changes, preparing for CECL requires that the financial institution adjust its loss allowance to be ready for the increased probability of default, which means the institution’s income could take a hit.
In order to minimize earnings volatility, the goal is to predict loss allowances as accurately as possible, which requires sufficient data. Adequate data analytics capabilities are like glasses to someone who is nearsighted, enabling them to see objects far away, or in this case, future economic conditions that may impact portfolio performance.
While the CECL implementation date of 2020 may seem far away, financial institutions should start prepping their data now. Identifying and remediating data gaps, along with bringing together a team of stakeholders from various departments within the institution will help ensure the accessibility and accuracy of its data for CECL compliance.
Optimize the origination process
Additionally, financial institutions should examine their loan origination process to determine if there are ways to increase efficiencies and consistencies across the process. Optimizing the consistency and efficiency of originations ensures that an institution has an accurate view of how changes in risk exposure will influence a loan’s performance.
Consistently monitoring data points captured at the time of origination helps to determine when there is a change in credit quality. This will ensure that an anomaly—like an inconsistently decisioned loan—does not impact an entire portfolio’s performance and its loss allowance.
Segment and repeat
To successfully segment loan portfolios, financial institutions should organize them so that loans performing similarly through different economic cycles are grouped together.
Start by categorizing loans based on the type and term of loan. The portfolio can then be segmented into separate pools of loans that perform similarly through various economic scenarios. Pools can vary greatly, as one pool may have loans that performed well through the recession, while another pool is comprised of loans that were severely impacted.
Effective segmentation requires time and consistent monitoring of portfolio performance, which means credit quality indicators will play an important role in compliance with CECL.
Continuously monitor portfolio performance
To understand how portfolios perform over time, financial institutions must regularly monitor for credit quality beginning at origination and throughout the life of the loan.
Collecting data points that indicate credit quality, such as FICO scores and debt service coverage, on a continuous basis will empower banks and credit unions to track and quickly identify what influences a portfolio’s performance.
Post-CECL Portfolio Predictions
Because CECL will change how financial institutions manage risk, this new standard could have several widespread effects that may not become apparent to the industry for some time.
With CECL, there is the potential for banks and credit unions to change how they use data to decision and monitor loans, as well as what types of loans and credit products they offer. CECL could also bring changes to loan pricing models and what types of borrowers financial institutions target.
CECL will inevitably shift the industry’s approach to lending, but enabling your institution to confidently calculate forward-looking loss estimates will result in an optimally-sized reserve with minimal income volatility.
Posted on October 17th, 2018 at 10:00 am
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