Current Expected Credit Losses (CECL) is an accounting requirement for many banks, credit unions, and, in some cases, non-financial institutions. And existing Allowance for Loan and Lease Losses (ALLL) processes will require numerous enhancements to be compliant. In the spirit of building an efficient organization, and since regulators often encourage consistency in capital management across the organization, many banks plan to integrate Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act Stress Test (DFAST) capabilities with CECL while the hood is up.
What Is CECL?
CECL is an accounting standard that impacts how financial institutions estimate allowances for credit losses. Issued in 2016 with a phased implementation approach throughout 2019-2022, CECL fundamentally changes the incurred-loss model previously used by institutions so that it’s less likely expected credit losses are underrepresented. Increased credit loss provisions also impact how each financial institution addresses risk and financial management within its organization.
What Is CCAR?
CCAR is a regulatory framework from the Federal Reserve that stress tests mandated banks’ capital adequacy. Banks submit a capital action plan for four quarters and are scored based on risk characteristics and assumptions in the event of extreme economic stress.
What Is DFAST?
DFAST is a stress test methodology that’s designed as a complement to CCAR. Both are intended to assess whether sufficient operating capital is on hand to endure unique risks and tough economic scenarios. The Fed runs these programs understanding that, while there is some overlap, redundant efforts and regulatory burdens are minimized as much as possible.
CCAR and DFAST Stress Tests
CECL implementation teams must understand what the CCAR and DFAST stress tests are and how they differ.
DFAST requires the Federal Reserve to execute a supervisory stress test using data submitted by the banks and requires them to run their own stress tests. Key financial attributes are modeled and evaluated to assess if enough capital exists to remain solvent under differing economic scenarios.
CCAR requires banks to submit proposed capital action plans to the Fed, who assesses whether the bank can maintain minimum regulatory capital ratios during times of stress. Each bank’s stress testing practice also undergoes a thorough qualitative assessment by the Fed.
While DFAST and CCAR tests are complementary, they are two different tests. CCAR gives banks more options to change capital levels and is only required for large banks. DFAST is required for both large and mid-sized banks; however, requirements for mid-sized banks are less strenuous with lowered expectations for model data granularity, sophistication of estimation approaches, reporting, frequency of tests, and public disclosures.
After years of running the stress tests, it’s safe to say banks have built dynamic stress testing operations, and fortunately, they can leverage some capabilities for CECL. Next, we discuss how the models used in stress testing can be re-calibrated for CECL.
Credit Loss Models
CECL replaces the backward-looking incurred loss model with a forward-looking expected credit loss model. Similar forward-looking credit loss modeling methodologies are in production for stress tests, including roll-rate based models, transition state models, and Probability of Default/Loss Given Default (PD/LGD) models.
No single estimation method is required for either stress tests or CECL, and the estimation method used for stress tests is typically chosen based on the bank’s size and complexity. For CECL, using a similar base methodology and segmentation for similar exposures ensures consistency and, as a bonus, these methodologies have already received approval internally by the bank and externally by regulators.
Banks may consider using stress test models as a starting point for exposures that overlap the allowance for credit losses and stress tests. Many components must be re-calibrated for CECL, such as:
- Stress testing models assume a non-static portfolio (e.g., loans entering through purchases and exiting through payoffs) whereas CECL requires a static portfolio (e.g., lifetime loss projections for a specific set of loans).
- CCAR projections are for 9 quarters, while CECL requires a timeframe extended through the life of the instrument.
- Large banks are required to create and use their own scenarios, which encompass forward-looking macroeconomic variables along with scenarios provided by the Fed, and mid-sized banks are only required to use Fed scenarios. Banks will need to evaluate if existing stress test scenarios are appropriate for CECL, or if they should create or source new ones.
- Stress testing models are inherently conservative given their focus on adverse scenarios only. Since CECL results will impact earnings and will be under scrutiny from investors, banks may want to reduce this inherent conservatism and the volatility of results by adjusting estimation assumptions and through qualitative adjustments.
Data and IT Infrastructure
CECL and stress test models are similar types of projections and use similar data elements. If the bank chooses to adopt a stress test methodology and segmentation for CECL, the data used in both models overlaps substantially. Due to the differences in model calibration, the existing data must be evaluated to ensure it supports the desired CECL estimation approach. Banks must gather data requirements and source information for missing data identified in this evaluation and for in-scope exposures where a stress test model is not available.
Stress testing technology platforms exist for the end-to-end modeling process, from data warehouses, to statistical modeling software, to reporting infrastructure. CECL implementation teams can plan to use existing IT platforms wherever possible, avoiding duplicative technology. Banks that use third-party IT stress testing platforms can engage the vendor to determine if it can support CECL modeling or if another vendor will be required.
While regulators require numerous controls for stress testing data, data controls for any attributes not currently used in Allowance for Loan and Lease Losses (ALLL) will require augmentation to be Sarbanes-Oxley (SOX) compliant.
Processes and Controls
Many banks will perform a gap analysis of the existing credit loss allowance process against CECL requirements to identify areas requiring enhancements as a preliminary step.
Stress testing processes can be used to fill some gaps rather than building a new process from scratch. For some banks, CECL implementation presents an opportunity to identify and consolidate functions that overlap the allowance process and stress tests.
Many stress testing processes may be leveraged or evaluated for use with CECL, along with internal control frameworks, model governance policies, and model documentation/validation templates.
The following considerations apply for any stress test process or control used for CECL:
- Increased Volume: Banks run stress tests either annually or semi-annually, depending on the size of the bank. CECL’s process will run quarterly to coincide with financial reporting cycles. Processes will require augmentation to support additional cycles.
- Cycle Time: Regulators release stress test scenarios two months prior to when results are due. For CECL, execution time must reduce significantly as models need to run using data finalized a few days prior to the accounting statement filing date.
- SOX Compliance: While regulators require numerous controls over the stress testing process, all controls are not necessarily SOX compliant. As with data, incremental process and control changes to the allowance for credit losses will require updates to be SOX compliant.
Many banks currently employ manual stress testing procedures. Given the potential augmentations required to support increased volume, cycle time, and controls, banks may want to use CECL as an opportunity to explore process automation to speed processes and improve controls while reducing costs.
Changes to the allowance for credit losses required by CECL will impact capital ratios. Since CECL will likely result in larger allowances and therefore lower capital ratios, banks will need to plan accordingly in subsequent CCAR and DFAST exercises.
With a better understanding of CCAR and DFAST, your CECL implementation team can begin to think about how to integrate stress test capabilities with CECL. For the modeling component of CECL, be sure your bank understands which CECL exposures already have an applicable stress test model. If so, you can engage your modelers to build incremental enhancements, as opposed to starting from scratch.
Contact CrossCountry Consulting today to get started.
Editor’s note: Updated January 2022