Static or Dynamic – Which Should be Your Approach to CECL?

Static or Dynamic – Which Should be Your Approach to CECL?

You Need to Soon Determine What Your CECL Model Will Be and Prepare Accordingly

 

According to NCUA Letter No. 16-CU-13, Current Expected Credit Losses (CECL) is not effective until December 31, 2021, but the NCUA states, “…your credit union needs to take steps in advance to ensure effective implementation of the standard. The board of directors and senior management of your credit union should become familiar with the new accounting standard to assess how the new accounting standard differs from the existing incurred loss model.” Preparation includes having a good idea as to the modeling processes to be used to implement CECL.

There are Basically Two Methodologies to Use for CECL

As the deadline approaches credit unions are preparing to change from the Incurred Loss model to the required Current Expected Credit Loss (CECL) model. The primary difference of the two models is calculating a loss ratio for loans based on expected losses over the life of loans instead of using actual losses from a previous period.

Two of the main methodologies or models suggested by FASB are Static Pool Analysis and Credit Migration. Each of these methods follows distinct paths to calculate a loss ratio for loans within disparate pools of loans. Understanding the differences between these methods can help Credit Union leaders make informed decisions as to which method will best serve their needs. So, let’s examine the key components of each method.

Static Pool Analysis

static pool is a group of loans that were originated during a time period in which all internal and external risk factors were basically the same. Once the pool has been established, no loans are removed from the pool and no loans are added to the pool; the pool remains static. For example, a static pool could include all direct loans originated in the year 2012. Another pool may be all loans originated in the “D” credit tier during the first quarter of 2014. So, any time either internal or external factors change, a new pool must be initiated. Static Pool Analysis has many weaknesses including:

• Requires significant statistical analysis

• Requires significant data collection and storage

• Only focuses on deteriorating loans

Credit Migration

Credit Migration, on the other hand, is a dynamic process that examines the movement of credit scores within each loan pool. Because of the dynamic nature of the credit migration, all loans are grouped by pools and monitored over time. The existing structure of the loan portfolio is maintained and applied. Clearly, Credit Migration is a better model for complying with CECL.

TCT’s Credit Migration Model is Superior to Others

TCT’s statistically back-tested and validated Credit Migration model provides a number of benefits for credit union managers:

Provides a better understanding of loan portfolios

○ Credit Risk can increase or decrease

○ A view into which risk pools are improving or deteriorating

Quickly identifies potential loan problems

○ Identify impaired loans and react to them early

○ Understand the risk in loan pools and adjust policies and procedures

Identifies opportunities

○ Recognize members who practice good borrowing habits

○ Proactively offer ways to help members

○ As a strategic tool for determining loan pools to increase or reduce risk

Applying precision in ALLL calculations

○ Statistically based calculations

○ Complies with regulations