April 2024

ACL Model Validation
Part II: Loan Portfolio Segmentation
By: Peter Warmenhoven, Consultant

Financial institutions have transitioned to the Current Expected Credit Loss, or “CECL” method of estimating the Allowance for Credit Losses. Following regulatory expectations, many financial institutions are evaluating the effectiveness of their CECL process and looking for ways to improve the accuracy of their CECL result.  One of the most basic yet important elements of the CECL process to evaluate is portfolio segmentation; the way institutions divide their loan portfolios into pools of loans with similar risk characteristics.  Proper segmentation is the foundation of an accurate ACL estimate.  From each loan segment, loss histories and loan lifetimes must be determined, cohorts can be identified, and relative qualitative adjustments are applied.

FASB ASC Topic 326, the CECL Standard, requires expected losses to be evaluated on a collective, or pool, basis when financial assets share similar risk characteristics. However, neither FASB nor the regulatory agencies have prescribed a specific process for segmenting financial assets into pools for collective evaluation. Depending on portfolio size, composition, and complexity, a pool segmentation that’s appropriate for one institution may not be appropriate for another.  While there is no definitive approach for an institution to segment its portfolio, the CECL Standard does provide these key guidelines:

• Segmentations or pools should have similar risk characteristics
• Pools should be as granular as possible while maintaining statistical significance
• Risk differentiation and economic responsiveness are key considerations
• Both credit and non-credit related characteristics are relevant
• Management should exercise judgment when establishing appropriate segments or pools
• Management should evaluate financial asset segmentation on an ongoing basis

Many institutions, especially community based financial institutions, have segmented their portfolios to some extent according to the Call Report Codes for Schedule RC-C, Loans and Leases.  For Call Report purposes, each institution’s loan portfolio is already segmented into standardized pools according to loan  purpose, collateral type, or borrower. The call code represents a common starting place that virtually all institutions already track.  After first segmenting by call code, CECL pools can be refined by other criteria to break out significant sub-pools, or even by combining segments into larger pools according to shared risk characteristics.

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