Solving the CECL Challenge

Presented by

Doug WrightCFO, Mission Federal Credit Union

andBryan W. Mogensen CPA, CLA (CliftonLarsonAllen LLP)

Doug Wright

• CFO, Mission Federal Credit Union

• 31 years in the credit union, banking industry

• 16 year CFO

• Member, FASB CECL Transition Resource Group

• MBA, Gonzaga U., BA, Univ of California, Berkeley

Bryan W. Mogensen, CPA• 25+ years working primarily with credit unions

• Speaker/Presenter at: – AICPA National Credit Union Conference

– ACUIA National Conference

– Various State League and Chapter Meetings

– CUES/CUNA

• Graduate of University of Wisconsin – Milwaukee, WI

• Member of: – AICPA

– Arizona Society of CPAs

• On the AICPA National Credit Union Planning Committee

Objectives

Provide CECL updates & timelines

Provide data & modeling recommendations

Tackle common CECL technical challenges

Evaluate CECL transitioning issues

Understand audit, back-testing & validation requirements

Consider business implications

4

Agenda• FASB & Regulatory Updates

• General Planning & Timelines

• Data Collection Insights

• Modeling Insights

• Buy vs. Build (& Maintain)

• Key Technical Challenges

• Transition & Post-Implementation Considerations

• Audit Insights

• Capital & Other Business Considerations

• Q&A

FASB Updates

TRG Meetings

– Potential topics provided by AICPA Depository Institution Panel, regulators, auditors, individual FIs, & FASB staff

– TRG Topics Discussed Include:• Non-PBE timing

• Reversion

• Purchased Credit-Impaired loans

• Troubled Debt Restructures

• Credit Card Receivables – estimated lives & loss estimates

• Recoveries

• Loan Extensions

Staff & Board Action

Regulatory Updates

• Bank regulators focused on CECL– Extensive internal discussion– Stronger guidance for large institutions

• CCAR & D-fast similarities• Expected modeling expertise/rigor greater

– Still struggling with smaller institutions• Data validity, model validity are issues• Balancing reasonable expectations and resource

constraints

• NCUA grappling with same issues

FASB Timeline Extension

Fiscal years after December 15, 2021 & interim periods within those fiscal years

Pushes back implementation to 2022; however:– 2022 interim periods required

CUs don’t generally issue interim statements; but– Form 5300s include ALLL, so effect could essentially

be adoption as of January 1, 2022 If required, a full year of 5300s before audit is

conducted…5300 restatement possibility NCUA may modify

CECL Implementation Plan & Timeline CECL Implementation Team - Done Developing basic CECL understanding - Done

– External resources (associations, vendors, other CFOs, etc.) Initial data evaluation – Done Data gathering & cleanup efforts – Basic done, but ongoing

through implementation Methodology/Model evaluation – 2018 - 2020 Buy vs. build – 2018 - 2020 Initial capital evaluation – 2018 - 2019 Parallel runs – 2020 - 2021 Implementation – 2022 Refinements – 2022 & Beyond

Data Collection Insights Data required depends on methodologies used

Roll rate Vintage PD/LGD Discounted cash flow

Many segments may not have statistically valid sample sizes Reduce sample size by more statistically precise techniques (multi-variate

regression, iterative processing) Sample size/lack of data can also be tackled with industry data

Economic cycle “expectation” presents interesting questions Valid data back to pre-2007? If so, is 2005/6/7 - current reflective of a reasonable cycle? How does this change in the next 3 years?

It’s likely that additional refinements will be required regarding data for the first 2-3 years after implementation

Data Collection Recommendations

Identify the methodologies you are most likely to use Identify critical inputs required:Loan specific infoEnvironmental & economic info

Do your best with historical data, but develop capabilities to retain & evaluate required data on a go-forward basis

Collect as much “useable” info as possible on a loan-specific level

Identify how you are going to overcome small sample sizes

Modeling/Methodology Insights

• FASB committed to allowing flexibility, but largely “uninvolved” post-implementation

• Regulators profess flexibility, but may gravitate to more common approaches Field examiner knowledge Institution comparability Vendor concentrations

• Different methodologies may yield “better” results for different segments

Modeling/Methodology Insights

Model “platform” should include areas to input & describe:o Historical basiso Current adjustments: qualitative & environmentalo Reasonable economic forecastso Reversion to historicalo Other key assumptions: prepayments, contractual lives, extensions

Model platform built with future in mind; how is the program going to be maintained & updated?

Discounted cash flow specifics:o Usually based on another methodology (e.g. PD/LGD)o Given other factors equal, will often result in lower estimated allowance

because future losses are discounted

Modeling & Methodology Recommendations

• Explore industry whitepapers/webinars on specific methodologies• Engage with several vendors to view approaches• If building one internally, consider:

– Platform requirements as noted previously– Ongoing maintenance from quarter to quarter– Validity, backtesting & “auditability”– Regulatory “defense”

• Applicability for other uses– Credit management– Credit stress testing– Loan/relationship pricing

Buy vs. Build Insights Vendors have committed significant resources to developing

models Platforms are still under development Most have worked with auditors, but none has been audited Pricing varies, depending on model complexity and institution

asset size Build extends far beyond initial platform development:

o Ongoing collection of data, maintenance & updating of model for each quarter, and model refinement

o Validation and “auditability”o Regulatory scrutiny

Buy vs. Build Recommendations

Contact and consider several vendors Beware of “CECL Compliant” claims Look closely at validation/explanation capabilitiesConsider cost vs. “performance” tradeoffsDon’t rush into a decision If build, note prior insights If build, work closely with auditor, regulator and

other independent parties for feedback

Technical Challenges

1. Credit cards

2. Loans formerly known as TDRs

3. PCI loans

4. Debt securities

Credit Cards

Unfunded credit lines No allowance if unconditionally cancellable

by issuer• Provision for unconditionally cancellable

• Most CUs have this provision

If not cancellable, record liability for unfunded commitments

Credit CardsEvaluate portfolio into:Transactors

• Pay off monthly

• Earn rewards

• Lower charge-offs

Revolvers• Retain monthly balance

• Most net interest income earned by these

• Higher charge-offs

Credit Cards

• Evaluate weighted average life– Payments based on activity (FIFO)

– Payments applied based on CARD Act• Higher APRs paid first

– Either method acceptable

• Determine loss emergence period– Period from loss-triggering event to charge-off

Troubled Debt Restructures (TDRs)• Individually impaired concept removed from ASU

2016-13

• TDR concept retained

• Initial indications – TDR credit losses measured using various CECL models

• But, FASB indicated that allowance must still consider full “economic loss”?

• Discounted cash flow measures economic loss

• Pending further clarification

PCD/PCI Loans

• Purchased Credit Deteriorated – loans that have incurred “more than insignificant deterioration since origination”

• More loans qualify as PCD compared to Purchased Credit Impaired (PCI)

• Discounts associated with credit loss added to reserve upon acquisition

PCD/PCI Loans

• PCD adjustments applied prospectively– Adjust amortized cost basis of loan to reflect

addition of the ALLL

• Not required to reassess current PCI loans meet definition of PCD

PCD/PCI Loans

Can elect to maintain pool of current PCI

Noncredit discount/premium, after ALLL adjustmento Accreted to interest income using interest method

on effective interest rate after ALLL adjustment for credit losses

Debt Securities

AFS:• Replaces OTTI impairment concept

• Determine if decline in fair value due to credit or other losses– If credit – post as allowance through income

statement (provision)

– If other (interest) – post through OCI

Debt Securities

AFS Use CECL model

Use an allowance instead of direct write-off (permits reversals)

Credit risk – post as allowance through income statement (provision)

HTM Treatment similar to loans held in portfolio

CECL reserve

Debt Securities

• Complex models not expected with plain vanilla portfolios

• For those with credit risk, requires reserve– Some municipals, private-label MBS

– Reassess allowance monthly

– Can reverse credit allowance up to zero

– Cannot have negative credit loss

Transition Considerations

Model and ALLL align with loan growth• Loan and related PLL booked on Day 1

Forecasting/Q&E• Should align with your ALM models

Transition Considerations

• Possible effects to:– Timing of loan promotions

– Loan discounts/offers

– Defer all loan origination fees and costs• Direct and indirect

Transition Considerations

• Net income challenges?– If book loan and PLL in Q1 then have

entire year to recoup income through loan interest

– If book loan and PLL in Q4 then have more PLL in CY and lower loan interest

Post-Implementation Considerations

Disclosures Back-testing & Validation Auditor Preparation & Testing

Disclosures

Detailed methodology & assumptions explanation

Credit quality “vintage table” (now likely including chargeoffs/recoveries by vintage)

Explanation of changes from prior periodo New loan volumes

o Historical factor changes

o Q factor changes

o Economic forecast changes

Back-Testing and Validation

Possible scenarios:– During testing phase

• Back-test charge-offs vs. projections

• Expected vs. actual correlations

• Ensure your model works as expected

– Use of another third-party vendor• Annual validation

Auditor Testing

• DIEP is drafting audit guidance practice aide– Currently 50 pages long

Auditor Testing

• Current issues being discussed:– Data challenges

• Current data – is it coded properly

• Old data – not all key data points captured by system

– Industry data• How can you audit/rely peer data when no access to

underlying data

Auditor Testing

• Reliance of a specialist– If you use third-party software model

– What kind of report can auditor use to rely on

• Not a SOC 1

Auditor Testing

• Risk based pools of loans– Test of controls over loan coding at origination

• Contractual terms– Test of controls over loan terms at origination

Auditor Testing

• Forecasts/Q&E factors– Quantifying forecasts

• Varied opinion by other institutions

• Varied opinions on where we are in economic cycle

• Who is correct

• Can both be correct

– ALLL Q&E align with ALM models• See auditors reviewing both to determine if they match or

align

Auditor Testing

• Reasonable and supportable estimate– Documentation must be enhanced to support

conclusions

• Testing of assumptions– Use of a specialist

– Use an internal/external validation model

Auditor Testing

• Data validation– Enhance tests of controls at origination to ensure

loans coded into correct segments, etc.

– Enhanced data analytics used to test portfolio

– Varied opinions on loan pools with similar risk characteristics

Capital & Other Business Considerations

• Regulatory Capital Impacts– Net worth/assets

– Total risk-based capital

• Consider earlier modeling, if:– Sub-prime concentrations

– Longer-lived assets

– Relatively close to regulatory net worth/asset minimum (9% or below)

• Cyclicality− Financial crisis− Recession in early

2020s?• Applicability for other uses

− Credit management− Portfolio concentrations− Credit stress testing− Loan/relationship

pricing

Any Questions?

If you have any questions regarding these guidelines please contact Josie Collins

jcollins@nafcu.org

703/842-2275