This article is the final one in our series of articles focusing on the different Current Expected Credit Loss (CECL) methodologies and their pros and cons. Previously, we have looked at the following methodologies:
In this article, we will look at the discounted cash flow method.
Financial institutions are probably familiar with the discounted cash flow method since it is often used to measure impairment of troubled debt restructurings. Most institutions will continue to use this method for individual impairment calculations that are not collateral dependent. However, applying this methodology to a pool of loans can be easier said than done.
How it Works
In a discounted cash flow calculation, a financial institution must project out the cash flows expected to be received over the life of each loan in a pool. This calculation requires several inputs that are based on historical data and/or expected forecasts. Most models will include the following inputs:
- Maturity date or remaining term to maturity
- Payment amount
- Interest rate
- Prepayment speed
- Constant default rate – Probability a loan in the pool defaults
- Loss given default rate – The expected loss rate if a loan defaults
- Recovery delay – Estimated time between the loss confirmation and amounts expected to be recovered (for example, from the sale of underlying collateral)
- Discount rate – The rate at which expected cash flows are discounted back to present value, which is generally the effective yield of the loan
Some of these variables can be readily obtained from an institution’s loan system, but others will require a lot of historical data and analysis. An institution can adjust applicable inputs directly in the model for current and forecasted changes. For instance, if an institution forecasts a change in interest rates that will affect prepayment speed or a change in collateral values that will affect loss given default rates and/or recovery delay, the institution can adjust these inputs for the anticipated effects.
Once the variables are determined, some computing power is required to schedule out the estimated cash flows for each loan and discount those cash flows. Because of the needed data, analysis, and computations for each loan in a pool, we believe institutions that want to utilize this methodology will obtain specialized software.
Pros and Cons
Most would agree the discounted cash flow methodology is the most precise CECL methodology because it utilizes a number of quantitative inputs and each of those variables can be adjusted for current and forecasted conditions, reducing the need for more subjective and less precise factors. In addition, this is the only methodology that discounts estimated future losses to present value. Consequently, this methodology should result in the smallest estimate of credit losses relative to other CECL methodologies.
However, a lot of work is needed to complete this analysis. Institutions will need to gather a lot of historical data and perform some significant analysis to determine the key variables in the model. Additional data will be needed to adjust the inputs for current and forecasted changes in those inputs. As a result, institutions will probably need to obtain specialized software to complete the analysis in an efficient manner on a regular basis.
The only methodology that discounts estimated losses, resulting in the lowest CECL allowance for credit losses relative to other CECL methodologies
Will require the most data and analysis to calculate the key variables and the qualitative adjustments
Qualitative factors can be directly applied to the inputs in the methodology, further “fine tuning” the resulting estimate
These calculations will probably require specialized software to complete the analysis in an efficient manner
The discounted cash flow methodology will result in the lowest possible CECL allowance for credit losses in almost all cases because it uses the most quantitative information (relies less on subjective analysis) and discounts those losses to their present value. Unfortunately, institutions that use this methodology will have to gather a lot of data, perform a significant amount of analysis, and prepare a not-so-simple calculation for each loan in the pool. However, the cost of preparing a discounted cash flow model may be recouped by being able to utilize additional capital not tied up in a CECL allowance for credit losses.
If you would like to discuss any or all of the available CECL methodologies in more detail at any time, please contact Brett Schwantes or your Wipfli relationship executive, and we would be happy to set up an appointment with you!
For more information on CECL, please check out our recent articles:
Measuring Credit Impairment of Financial Instruments
Investigating CECL Methodologies
CECL: Getting Started
CECL Methodologies Series: Cumulative Loss Rate
CECL Methodologies Series: Vintage Loss Rate
CECL Methodologies Series: Migration Analysis
CECL Methodologies Series: Remaining Life
CECL Methodologies Series: Probability of Default