Nearly a decade ago, the Financial Accounting Standards Board (FASB) issued the CECL standard, ASC Topic 326‡. This standard requires all financial institutions, regardless of size, to measure expected credit losses for loans and other financial assets based on historical experience, current conditions, and reasonable forecasts. The CECL model replaces the previous “incurred loss” model with a forward-looking approach that recognizes credit losses much earlier.
The institution type determined the staggered implementation timeline:
- Public business entities (PBEs) or SEC filers implemented the CECL standard for fiscal years beginning after December 15, 2019.
- To help mitigate transition complexity, regulators pushed the effective date for all other entities, or non-PBEs, to fiscal years beginning after December 15, 2021.
Methodologies and the importance of validation
FASB’s ASC Topic 326 provides institutions with guidance and flexibility regarding calculation methodologies. Banks can select a method that best aligns with their data availability and institutional complexity, including:
- Discounted cash flow (DCF)
- Loss rate method
- Probability of default (PD)
- Vintage analysis
- Weighted average remaining maturity (WARM)
The legacy incurred loss model delayed loss recognition until banks deemed a loss “probable.” This framework often produced inadequate reserves during economic downturns, most notably during the 2007–2009 financial crisis. By requiring institutions to recognize lifetime expected losses upfront, CECL aims to create a more stable financial system where banks can better prepare for credit downturns.
Because CECL is forward-looking, it broadens the scope of data required for loss estimation. It requires us to consider past events, current conditions, and reasonable, supportable forecasts that affect collectability.
Interest rate risk (IRR) and CECL validations share some similarities—both focus on data inputs, assumptions, back-testing, and forward-looking analysis. Given the inherent complexity of these predictive models, independent validation is essential to ensure regulatory compliance and financial accuracy.
Why CECL validation is essential
The CECL guidance, ASC Topic 326, gives financial institutions flexibility to develop their own methodology or use a third-party vendor to calculate reserves. This flexibility makes the CECL validation process challenging as you peel back the layers of a model, which can vary in complexity and sometimes is an exercise in data forensics.
Financial institutions can also face challenges when choosing a third party (internal or external) to validate their CECL model, as they weigh costs and evaluate the team that will review their data. Here, we cover best practices for preparing for a CECL model validation and share insights we have gained from the CECL validation process.
CECL validation checklist
Preparing and presenting your institution’s CECL data and documentation ensures an effective validation. The following is a general checklist of what to do to prepare for your institution’s CECL validation:
- Review documentation for both assumptions and methodology
- What model type are you using?
- How are you segmenting your loan pools?
- Why is your lookback period appropriate?
- What source data are you utilizing for your economic forecast?
- What qualitative factors are you incorporating? How were the assumptions determined?
- Review your CECL model and all supporting models utilized for CECL
- Do your balances tie back to your general ledger?
- Is your historical data complete?
- Are there any missing fields?
- Are control points satisfied? If not, are there supporting explanations?
- Review your CECL policy, asset-liability committee (ALCO) or board meeting minutes, and verify documentation of any assumption changes
- Perform a back-test on your CECL model
- Compare your calculated CECL reserves to actual loan losses by individual loan or by loan risk pool
- Perform stress tests on your CECL model
- Prepare your data to be shared with the validation team including:
- CECL Policy
- Memos on methodology and assumptions (if not included in your policy)
- Documentation on qualitative factors and assumptions (if not included in your policy)
- Supporting data for your economic forecast variables
- CECL model and supporting models, including historical data used to calculate loss factors
- CECL model change log (if applicable)
- Back-testing results
- Stress test results
- Third-party documentation from your CECL vendor
By setting up time to discuss these components with your CECL validation team, you can save your institution time and money. Too often, institutions hand over this data, and it is either incomplete or they do not take the time to educate the validator. When the validator presents the initial validation results, information is often missing, or the institution is challenged about an input or assumption because the validator did not see the information or misunderstood the process.
It can take multiple iterations to work through these details. When choosing your validation team, be wary if they do not request time to meet with you to review the information you provide, especially if you use an external third-party vendor that charges by the hour.
UMB’s intentional modeling program
Our team validates your CECL model by conducting an in-depth analysis of how you calculate the estimate for your allowance for credit losses and by providing a comprehensive review of your CECL methodology. Because every institution has a unique balance sheet composition, we tailor our CECL model validations to your institution’s structure and needs.
By working closely with key members of your institution throughout the validation process, we leverage our team’s extensive experience in model assessments and validations to examine your CECL model and assure your board and management that you incorporate best practices when generating your results.
We have observed external third-party validators focus on immaterial “gotcha moments” in their validation reports to the ALCO and the board to justify their process and expense. Instead, we aim to come alongside your team to ensure the CECL model accurately reflects your inputs and assumptions, that your documentation and policies align with the model, and that we provide your institution’s ALCO and board with a validation report that builds confidence in the reliability of the information your team produces.
Below is a general example of the process we follow during CECL validations. As mentioned earlier, because institutions can develop their own methodologies, we do not use a one-size-fits-all validation report. Instead, we design validations tailored to your institution.
UMB’s CECL validation provides an analysis of the following:
- The processes by which the CECL model is updated and approved, including documentation on roles and responsibilities.
- The appropriateness of the CECL model methodology given the size and complexity of the institution.
- The accuracy and completeness of data inputs into the model.
- The reasonableness and validity of assumptions and qualitative factors.
- The soundness and sufficiency of CECL measurement calculations.
- The identification of any model weaknesses or limitations, or other areas that may require ongoing monitoring or remediation.
- If a third-party vendor is being utilized, we review all documentation provided.
Impact of CECL model validation
Institutions must periodically validate their CECL model because the calculated CECL reserves impact earnings, capital, board reporting, and regulatory exams. Whether your institution validates its CECL model internally or uses a third-party provider, it is essential to thoroughly prepare and engage with your validation team.
In addition to running CECL models for our clients, the Financial Services Group (FSG) at UMB Bank Capital Markets Division also performs CECL model validations. Learn how UMB Bank Capital Markets Division’s fixed income sales and trading solutions can support your bank or organization, or contact us to be connected with a team member.
About the authors:
Jenifer Plummer is senior vice president and senior financial analyst at UMB Bank, n.a., Capital Markets Division. She provides client support as well as providing CECL assessment and validation services.
Katie Shands is vice president and senior financial analyst at UMB Bank, n.a. Capital Markets Division. She is responsible for providing asset liability management services to our clients.
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