As previously mentioned in Part 2 of this ACL Model Validation series, financial institutions have recently transitioned to the new Current Expected Credit Loss, or “CECL” method of estimating the Allowance for Credit Losses (“ACL”). While much about the CECL method is unfamiliar, and while ACL calculation models vary, there are a few basic similarities with the previous incurred-loss method. First, historical loss information still provides the starting point and figures heavily into the “quantitative” calculation of an institution’s ACL.
Further, the CECL method still incorporates adjustments for qualitative and environmental factors into the ACL calculation, to adjust for how current or forecasted conditions differ from historical loss experience. The purpose of qualitative factors is to adjust for what is not in the historical loss analysis. An important difference with CECL is that management should apply a forward-looking thought process when evaluating these criteria. Q-factor adjustments should address the differences in the current environment, and the current or expected conditions that indicate that future loss rates will be different than losses incurred in the past.
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.
In June 2016, the FASB issued ASU 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” The ASU and its subsequent amendments (collectively referred to as ASC Topic 326) became effective for all entities beginning in 2023. ASC Topic 326 instituted the Current Expected Credit Loss (“CECL”) methodology for estimating Allowances for Credit Losses (ACL) and eliminated the previous incurred loss allowance methodology used by financial institutions for decades.
Now that your institution has implemented the Current Expected Credit Loss method of estimating its Allowance for Credit Losses, what remains to be done? What will regulatory agencies look for in terms of evaluating your institution’s CECL compliance? Moreover, what should you do to prepare for your first regulatory exam since implementing CECL?
Whether your ACL model and process was developed within your institution or by a third-party vendor, have your process reviewed independently for conceptual soundness and compliance with the ASC Topic 326 standard.
As stated in the Interagency Policy Statement on Allowances for Credit Losses (revised April 2023):
“After analyzing ACLs, management should periodically validate the loss estimation process, and any changes to the process, to confirm that the process remains appropriate for the institution’s size, complexity, and risk profile. The validation process should include procedures for review by a party with appropriate knowledge, technical expertise, and experience who is independent of the institution’s credit approval and ACL estimation processes. A party who is independent of these processes could be from internal audit staff, a risk management unit of the institution independent of management supervising these processes, or a contracted third-party.”Find it here.
How will the supervisory agencies evaluate your institution’s ACL estimation process under CECL?
Examiners will first review and evaluate your institution’s ACL Policy for conformance to the standard and supervisory guidance. Make sure your ACL policy is reviewed and properly approved by your board of directors at least annually. Also, keep in mind that ASC Topic 326 fundamentally involves management’s estimate of expected credit losses, requiring significant management judgment. Accordingly, the new standard provides significant flexibility in the method or approach used to estimate credit losses. As part of their supervisory activities, however, examiners are expected to “assess the appropriateness of management’s loss estimation processes and the appropriateness of the institution’s ACL balances.” Throughout the Interagency Policy Statement referenced above, the terms “appropriate,” “reasonable,” “supportable” and “documentation” occur a myriad of times with respect to examiners’ assessment of management’s assumptions, methods and process, and the overall ACL. For each quarterly ACL estimate, be prepared to share with examiners the written rationale supporting management’s estimation process, including the assumptions, forecasts, and qualitative adjustments used.
Throughout 2023 and 2024, our team has worked with a number of clients to validate their approach and offer further guidance on the ongoing ACL process. As most community-based financial institutions approach the first anniversary of this “new” accounting treatment, many may not have experienced a regulatory review since its implementation, lacking regulatory insights to the new ACL process. Conducting an ACL Validation will help identify areas for improvement either preemptively or in preparation for regulatory feedback.
As we begin a new year, the financial landscape is evolving at an unprecedented pace. Despite the whirlwind of technological advancements and the ever-changing dynamics of the banking industry, there exists a set of principles that stand the test of time—The 5 C’s of Credit. In this blog, we delve into the enduring relevance of these timeless principles and their fundamental role in navigating the complexities of the financial realm.
Timeless, as defined by Merriam-Webster, is not restricted to a certain time or date. The concept of timelessness can be applied to many factors involved in commercial lending. While technological advancements in credit underwriting can make complex and difficult financial analysis seem easy, the basic tenets of commercial lending remain steadfast. These central principles included within Character, Capacity, Collateral, Conditions, and Capital provide the foundation for nearly every lending decision.
Character: The Foundation of Trust The first of the 5 C’s, Character, remains the bedrock of sound lending practices. In an era dominated by algorithms and data analytics, the assessment of an individual’s integrity, honesty, and reputation remains unparalleled. The timeless nature of character evaluation ensures that trust, a currency more valuable than ever, continues to be a cornerstone in lending decisions.
Capacity: Navigating Financial Waters Capacity, the second C, addresses the borrower’s ability to repay a loan. Despite the advent of sophisticated financial models, the ability to understand and analyze an individual or business’s capacity to meet financial obligations remains a linchpin in prudent lending. This timeless principle involves both art and science as borrowers face a continuously evolving economic landscape, proving its relevance in diverse financial scenarios.
Collateral: A Tangible Safety Net Collateral, the third C, provides a tangible safety net for lenders. While technological innovations have introduced new ways of assessing collateral value, the fundamental principle of understanding the various nuances of pledged assets remains steadfast. The ability to understand how collateral may be impacted by changing market conditions ensures that this timeless principle remains effective in mitigating risk.
Can you believe it? Five years have passed since we embarked on this incredible journey, and we couldn’t have done it without you. We are thrilled to celebrate our 5th year in business, and we want to take a moment to express our heartfelt gratitude for your support. This milestone not only represents our achievement but the trust and loyalty you’ve shown us throughout this adventure.
Our success story is incomplete without the remarkable people who have supported us from day one — our customers. We want to extend our deepest gratitude to each one of you. You are the reason we are here today, and we promise to keep exceeding your expectations.
And to our team – we want to extend our heartfelt appreciation to our consultants who have been a driving force in our success. experience, hard work, and dedication has allowed us to expand into five states across the Upper Midwest, serve over 50 financial institutions, review over 2,300 credit relationships, and almost $14 billion in total portfolio commitments.
As we celebrate this milestone, we’re not just looking back; we are also looking forward to the exciting journey ahead of us. We value your feedback, and we remain motivated to keep improving.
Our 5th-year anniversary is not just about our accomplishments; it’s a celebration of the relationships we’ve built and the community that surrounds us. Thank you for choosing us as your trusted partner, and here’s to many more years of growth, success, and shared moments. We look forward to continuing this next chapter with you!
ACL Model Validation
Financial institutions have transitioned to the Current Expected Credit Loss, or “CECL” method of estimating the 
