Fed Releases Tool to Help Community Banks Implement CECL… But is it Right for Your Institution?
In July, the Federal Reserve (“Fed”) released a tool to assist community banks in implementing the Current Expected Credit Losses (CECL) standard for estimating allowances for credit losses. Referred to as the Scaled CECL Allowance for Losses Estimator, or “SCALE,” the method and related spreadsheet-based tool aim to simplify the credit loss estimation process for institutions with total assets of less than $1 billion by leveraging peer data from publicly-available regulatory reports.
While the beauty of SCALE is in its simplicity, it may or may not be an appropriate methodology for your institution.
How Does the SCALE Method Work?
In the July 15 Ask the Fed webinar, hosted by the Fed in order to showcase the tool, the SCALE method was broken down into four primary steps, as follows:
Calculate expected credit losses for loans evaluated on an individual basis
The first step is to identify loans that do not share similar risk characteristics with any identified loan pools. These loans will be removed from their respective pools and losses will be evaluated separately in a manner similar to how impaired loans are evaluated under the incurred loss methodology (the tool has a separate tab to track such loans).
Enter proxy expected lifetime loss rate
This step serves as the foundation on which the SCALE method is based. Institutions can leverage expected loss data from institutions with total assets of $1 billion or more that have already adopted CECL by using data from Part II of Schedule RI-C of the Call Report for select peer institutions as a proxy for an institution’s expected loss rate. By calculating the allowance for credit losses as a percentage of the amortized cost for each loan segment using the information in Schedule RI-C, institutions can apply these loss percentages to their own portfolios to arrive at a starting point of the estimated lifetime loss rate.
BNN observation: Management is ultimately responsible for determining the appropriateness of the selected peer group. As such, management should document its rationale for which institutions are included in the peer group used to determine the proxy expected lifetime loss rate. While the use of a national peer group may be appropriate under certain circumstances, institutions should consider whether a peer group with credit risks similar to their own is more appropriate. Selection of a more defined peer group could also result in qualitative adjustments that are less in magnitude as compared to qualitative adjustments to a national peer group.
Adjust for qualitative factors
For institution-specific information that isn’t already captured in the proxy expected lifetime loss rate, institutions will need to make certain qualitative adjustments, including any forward-looking adjustments that are unique to the institution. Representatives from the Fed directed prospective users of the SCALE model to the Interagency Policy Statement on Allowances for Credit Losses for a list of potential qualitative factors management should consider. This process should sound familiar as it is similar to the current process under the incurred loss methodology with the addition of forward-looking considerations; however, given that the proxy expected lifetime loss rate has the selected peer group’s qualitative adjustments “built in,” adjustments to reflect an institution’s own facts and circumstances will tend to be less in magnitude as compared to other CECL methodologies. As with the current approach, institutions will need to maintain documentation to support any qualitative adjustments (or absence thereof) made to the proxy expected lifetime loss rates.
Adjust proxy expected lifetime loss rate to reflect the institution’s insight on portfolio performance
The final step under the SCALE method is to input the institution’s net loss rate and its peers’ average net loss rate from 2007-2020 as reported in the Uniform Bank Performance Report (UBPR). These loss rates are then compared and an adjustment is made for the difference, either positive or negative. Although the SCALE tool is designed to capture this information on the portfolio as a whole, representatives from the Fed indicated that specific adjustments to each portfolio segment may be deemed more appropriate by management.
BNN observations: While the spreadsheet-based tool contains fields for users to input net losses from 2007-2020 with the intent of capturing losses through a full economic cycle, the responsibility for determining an appropriate timeframe rests with management and will need to be reassessed each reporting period. The previous observation regarding the identification of an appropriate peer group applies here as well.
The Fine Print
The regulators noted that the SCALE method is one of many acceptable methods an institution can use to implement CECL but it is not a regulator-preferred method nor is it a safe harbor methodology. Institutions are responsible for determining whether the method is appropriate in light of their own unique facts and circumstances. If the SCALE method is applied, institution management is responsible for ensuring compliance with U.S. Generally Accepted Accounting Principles (GAAP). It should be noted that a representative from the Financial Accounting Standards Board participated in the July 15 webinar and it appears that the SCALE method would be GAAP-compliant if applied properly. Representatives from the Fed have indicated that although other regulatory agencies have reviewed the model, management is encouraged to discuss the suitability of its use with their regulators.
Is the SCALE Method Right for You?
The SCALE method was designed with small, noncomplex community banks that follow a traditional community banking business model in mind. Nevertheless, it will be up to each institution to determine whether the model is appropriate based on the risk characteristics that exist in its loan portfolio. As with all other CECL models, this determination should be documented.
One of the primary benefits of the SCALE model is the limited amount of data necessary to apply the model as compared to other models. The model also mitigates the challenge of developing reasonable and supportable forecasts by utilizing peer lifetime loss rates that have built-in forecasting assumptions. As with many financial models, however, there tends to be an inverse relationship between simplicity and precision. Given the SCALE method’s relative simplicity and heavy reliance on peer data, institutions should understand that the result may not be as precise compared to other models and would need to ensure it falls within a reasonable range.
Accounting Standards Codification Topic 326, where CECL is codified, requires institutions to measure expected credit losses on a collective or pool basis when similar risk characteristics exist. As noted in the Fed’s FAQs on SCALE, if management concludes that the portfolio segments used in the SCALE tool are not appropriate for the size, complexity and risk profile of the institution, use of another CECL method may be necessary.
As this model is only available for use by institutions with total assets of less than $1 billion, institutions that are considering an acquisition or that are approaching the $1 billion threshold should probably consider another method. Also, institutions that are already well underway in their CECL implementation efforts likely won’t get much benefit from this model. Smaller, non-complex institutions struggling to make meaningful progress in their CECL implementation efforts may find SCALE to be a viable solution though it is by no means a panacea; management will still need to determine use of the model is appropriate under the institution’s circumstances, populate the necessary data and make appropriate qualitative adjustments. Each of these decision points and processes should be well-documented and should hold up to scrutiny from auditors and regulators.
As a friendly reminder, CECL is effective for all entities other than public business entities that meet the definition of an SEC filer (excluding entities eligible to be smaller reporting companies) for fiscal years beginning after December 15, 2022. Early adoption is permitted.
A link to the Fed’s SCALE resource page, which includes the SCALE tool and a list of FAQs, can be found here. Readers are also strongly encouraged to review the Interagency Policy Statement on Allowances for Credit Losses for an understanding of supervisory expectations on examiners’ review of the allowance for credit losses. Finally, BNN has a CECL Resource Center with a toolkit available for download which contains a variety of CECL-related resources aimed at assisting institutions in their path to implementation.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.