CECL optimization and absolute cost
The Current Expected Credit Loss (CECL) accounting standard provides for more timely recognition of credit losses. One of the key aspects of CECL is to select the right methodology to estimate ECL so institutions can cover these losses by holding the right allowance.
Each CECL method gives a different result. Banks can optimize by checking which method will give them the lowest CECL result and then choose accordingly. This will give them maximum capital to channel into the markets, as they will need to hold the least amount of cash as risk capital. The lowest CECL estimate is also called Absolute Cost.
The challenge is that the next CECL estimate could be much higher. This poses a liquidity problem for banks that do not have these reserves and would therefore need to make up for it by selling assets. Some banks may tackle this liquidity problem by creating an extra buffer of reserves over and above the capital CECL asks them to hold.
Risk appetite management
While institutions might find it appealing to opt for methods that give the lowest CECL estimates, they will have to manage the corresponding risks by building a capital buffer. The size and scale of the buffer indicates an institution's risk appetite — a zero buffer means a higher risk appetite, while a huge buffer indicates aversion to taking risks.
Another way to manage risk appetite is to calculate CECL using the current scenario and then for an extreme scenario (where unemployment, housing, and GDP factors are amplified). This indicates which methods are most sensitive to market movements and which are least affected. Banks can then pick methods that do not cause drastic changes in CECL numbers and therefore manage their liquidity flows better.
Volatility of CECL results
Certain CECL methods can produce more volatile results than others. Institutions looking to reign in volatility might advise their Board on which method to choose to stay within their buffer limits. But if the board decides to save as much capital as possible and channel it back into the markets, they might choose the method with the lowest result. The risk-averse nature of the board ultimately decides how they deal with CECL volatility.
Institutions will realize that the way they manage their buffers represents best practice for liquidity management and optimization against volatility. CECL has introduced a much-needed and improved measure of liquidity management.
CECL, risk management, and return on investment
Most regulations such as CECL require more capital to be held in reserve to account for predictive losses. This means less capital for banks to put into the market and significantly lower returns. The 2008 financial crisis ensured appropriate regulations were put into place so banks would have sufficient capital to deal with market shocks. In the longer term, CECL ensures banks maintain a good grip on liquidity management through sound risk appetite practices, leading to a more robust banking system.
CECL Express can help…
CECL Express is a turnkey solution that fully satisfies all elements of the new CECL accounting standard. The system provides all non-loan data, including:
- Yield curves and Fed data
- Linked reports on losses from the FFIEC and NCUA
- PD and LGD curves
- Macroeconomic data
Banks and credit unions need to only provide the underlying loan details for the system to provide fully auditable ECL results for multiple calculation methods, including:
- Vintage
- Roll Rate
- Discounted Cashflow
- WARM
- PD/LGD
CECL Express provides more than valid ECL results. The system computes results for all methods and all loan pools, allowing the bank to optimize its CECL configuration and avoid the worst impacts of the new standard.