The Current Expected Credit Loss model (CECL) is top of mind for most financial institution executives—if it isn’t, it probably should be. As we’ve discussed previously, the accounting standard that introduced CECL is going to be one of the most significant changes to financial institution accounting in at least a generation.
Monitoring the process used to develop the allowance for loan losses has always been an important role for what generally accepted auditing standards refer to as “those charged with governance.” Since the people charged with governance at a financial institution are typically the Board of Directors and/or a committee of the Board (e.g., audit committee or supervisory committee), we will refer to “those charged with governance” as the Board in this article.
A key outcome of the new credit impairment standard is the need for even more judgment to come up with an estimate for expected loan losses. No matter the methodology used, management teams will have to spend more time and effort supporting more variables, inputs, and assumptions to determine the appropriate allowance for loan losses. Because this process will require more significant management estimates, active monitoring and evaluation by the Board will be more important than ever.
CECL implementation is going to be a significant undertaking for all management teams. An action plan should be developed to guide the implementation process so the transition can be as smooth as possible. Such a plan might include the following:
- Identify and dedicate resources (internally and externally) to the implementation process.
- Identify appropriate loan pools.
- Investigate different CECL methodologies and identify the ideal methodology for each loan pool.
- Assess the current state of the institution’s allowance for loan losses process.
- Create a “gap analysis” (how do we get from here to there).
- Accumulate necessary data.
- Develop a roadmap for implementation.
Given the significance of this transition, the Board should actively monitor the institution’s progress toward CECL implementation. The Board may choose to create a committee just for this purpose. At a minimum, the Board should hold management accountable for developing an action plan and working toward each applicable milestone.
As processes change to produce the new estimate of expected losses, internal controls will also have to change to, at a minimum:
- Verify the completeness and accuracy of the underlying data used.
- Verify the accuracy of the data when it is transferred to the CECL model.
- Verify judgments and estimates are properly supported.
- Verify the accuracy and reasonableness of the reported allowance for loan losses, including appropriate disclosures.
It is the Board’s responsibility to monitor these and other internal controls to help ensure the allowance for loan losses is accurate, reasonable, and supportable. This is especially important for CECL because of the significance of the new estimate.
Model Risk Management
The Board will have a significant role in overseeing the CECL methodology and model after it is developed and implemented. The new CECL model may be maintained internally or by a third party. It may be relatively simple or fairly complex. Whatever the case, it will be more significant than current ALL models used today. Consequently, it will be vital for the Board to verify policies and procedures are in place to mitigate risks inherent in the model, which might include:
- Inaccurate data.
- Management bias.
- Calculation error.
- Unreasonable and/or unsupportable assumptions.
- Insufficient validation of results.
The Federal Reserve Board and the Office of the Comptroller of the Currency have issued Supervisory Guidance on Model Risk Management (FRB SR 11-7 and OCC 2011-12) that details various model risk management considerations for institutions. The Board should address these and other risks that will arise with the new CECL model during and after CECL implementation.
Although management will be responsible for the design and implementation of CECL methodologies and loan losses estimates, the Board should take an active role in monitoring the process and holding management accountable for the transition. Although the effective date for most nonpublic institutions is 2021, this date will come all too fast. It will be critical that institutions create and follow an action plan and dedicate resources to the process, and the Board can make sure the management team makes this a priority so the transition can go as smoothly as possible. For information on CECL, including ways the Board can become actively involved in the implementation process, please contact your Wipfli relationship executive or Brett Schwantes.