CECL adoption: What bank leadership teams can do next

Kevin Brand, Patrick Vernon, Alex Campbell

How is the CECL standard affecting bank financial statements? How should banks respond going forward? Crowe specialists explain.

Now that virtually all banks have made the transition to the current expected credit loss (CECL) standard for estimating their expected credit losses, many bank boards and management teams are wondering what’s next. How will the new CECL standard affect their allowance calculations? What impacts can they expect to see on their financial statements and related ratios? And what steps should they be taking now that their initial CECL implementation is complete?

The experiences of prior CECL adopters can help answer such questions, especially in view of the exceptional circumstances of the COVID-19 pandemic that coincided with many banks’ transition to the CECL standard. Board members – and audit committee members in particular – can apply some of the lessons learned by prior adopters as they move through their banks’ CECL implementation and fine-tune their models.

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The impact of CECL

The COVID-19 pandemic and the subsequent federal stimulus provided an unusual – and unexpected – test of the CECL standard. The test was made even more instructive when regulators agreed in March 2020 to allow some banks to delay the previously mandated adoption of the new standard. In comparing the median allowance for credit loss (ACL) numbers of those banks that already had adopted CECL with those that delayed implementation, the impact of the new standard is clearly visible. (See Exhibit 1.)

Exhibit 1: CECL adoption impact

_{Source: Crowe analysis, assembled from financial statements publicly filed with the Securities and Exchange Commission (SEC).}

_{Note: Q1 2023 data does not include institutions that have not filed financial statements with the SEC as of May 17, 2023. This chart has been accumulated from publicly available information. The process inherently introduces risk of error. Crowe LLP does not warrant this information is error-free. As such, reliance cannot be placed on this information. Users should be aware errors might exist in this chart. This chart is for informational purposes and is not a substitute for legal or accounting advice.}

As the exhibit illustrates, those banks that adopted CECL increased their ACL by a median of 22 basis points upon initial adoption on Jan. 1, 2020. Moreover, with the onset of COVID-19 in the first and second quarters of the year, they built up the allowance much more quickly than those banks that were still using the incurred loss method.

This divergence could be interpreted as a sign that the CECL standard was working as intended. As a forward-looking approach, CECL calculations were more adaptive to changes in forecasts, which enabled banks to be more responsive to newly perceived risks and changing economic conditions. On the other hand, incurred loss models, which were limited to historical perspectives, might have left some banks with a smaller allowance and as such potentially unprepared for an economic downturn if it were to manifest.

The pros and cons of the two approaches are still the subject of some debate. CECL proponents point to the ability to build the allowance more quickly when warranted, while critics express concerns that CECL models’ procyclicality can magnify fluctuations in an economic cycle.

The disparities in allowance levels eased significantly over subsequent quarters. CECL adopters were able to release the allowance faster when their anticipated losses were not realized and their models began to accommodate the exceptional levels of government intervention and subsidies that were provided. None of those factors could have been anticipated in the initial modeling.

Allowance versus charge-offs

A comparison of CECL adopters’ median ACL levels with their actual quarterly charge-off averages provides some additional insights. (See Exhibit 2.)

Exhibit 2: ACL and charge-off trends

_{Source: Crowe analysis, assembled from financial statements publicly filed with the SEC.

Graph Values: Small: Less than $8B
Midsize: $8B-$60B
Large: $60B-$1T
Mega bank: Greater than $1T

Note: Q1 2023 data does not include institutions that have not filed financial statements with the SEC as of May 17, 2023.}

For example, during the period shown in the ACL portion of the exhibit, large and mega banks’ ACL represented a significantly higher percentage of total loans – again, this is not unexpected, given large banks’ greater exposure to macroeconomic events. Actual charge-offs, however, represented a far smaller percentage of the total portfolio than the allowance numbers would suggest.

Although allowances were released and trended toward pre-pandemic levels during much of 2022, institutions began slowly building allowances in the last two quarters of the year and the first quarter of 2023 given the effects of rising interest rates and the anticipation of a recession. This trend has been particularly true of the larger institutions. Data from SEC filings also revealed some regional variations, with banks in the Midwest and West building allowances faster than other geographies between Dec. 31, 2022, and March 31, 2023. Despite slowly building allowances, average net charge-off activity has yet to increase substantially, especially among small and midsize institutions.

Generally speaking, later adopters experienced a smaller average impact from the CECL transition than the initial adopters did. Ultimately, however, both the prior and more recent adopters now have similar average reserve levels. These trends were explored in more detail during a recent Crowe financial services audit committee overview webinar. As noted in that session, the bottom-line lesson of the first few years of the CECL standard is clear: Under CECL, allowance levels change more quickly, and short-term trends can have a more noticeable and immediate impact. Bank leadership teams will need to bear that in mind as they fine-tune their approaches.

What boards can do

After spending significant amounts of time and resources to develop and implement their CECL methodologies, it is essential that directors and audit committee members regularly monitor their CECL models’ performance and understand how the models respond to inputs. Here are six important questions board members should ask as part of their ongoing monitoring:

Are the models still appropriate? Begin by determining that the models chosen still reflect the bank’s underlying portfolio risk. That means clearly understanding the factors and assumptions – both internal and external – that drive the models. The answers will be different for every organization and will evolve over time. In addition to addressing any changes in the loan portfolio or general business strategy, management should regularly revisit decisions about data set development, segmentation, prepayment assumptions, and the weighting of various other factors.
How should macroeconomic variables and forecasts be applied? It is important to understand how forecasting components are incorporated into the CECL model. Banks may choose to apply them from the “top down” – as part of the model’s qualitative factors – or from the “bottom up” at the individual loan level. Directional consistency is also important. When economic factors move in a negative direction, allowance requirements should increase appropriately. At a broader level, boards also should assess whether the specific macroeconomic factors that drive the model are still relevant to the bank’s portfolio or if a different composition of factors should be considered.
How are qualitative factors calibrated? Under the CECL standard, banks still apply various qualitative factors to adjust their models’ quantitative estimates of the needed allowance. The original 2016 CECL standard (Accounting Standards Update 2016-13) and subsequent guidance from federal banking regulators list a range of factors – from general economic and business conditions to bank-specific features such as credit concentrations, collateral value, and loan quality – that banks may consider in this process. At a minimum, banks should reevaluate the composition of these factors annually to be sure they are still appropriate and reasonable, and they should recalculate the basis point impact of each factor quarterly.
Are the models functioning as expected? Under CECL, banks’ financial models will produce specific projections of expected losses over a period of time. In addition to comparing those projections with actual results, banks also should apply more advanced techniques such as back testing, parallel testing, historical performance monitoring, and similar practices to test the sensitivity and accuracy of their models and identify any weaknesses or adjustments they should make.
How are off balance sheet risks such as unfunded commitments being modeled? Because these risks are sometimes overlooked, board members should make sure management is modeling for such risks and accurately reflecting historical funding expectations. This includes regular monitoring of credit lines and loan funding trends, with a particular focus on pool-specific loan performance – such as construction loan funding levels – to verify that CECL models are incorporating these variables appropriately.
Is appropriate model validation being performed? After the initial model validation process at the beginning of the CECL implementation, banks will need to repeat the effort periodically to confirm the continued effectiveness of their chosen models. There is no single prescribed schedule for revalidation, but many prior adopters are planning on a full validation every other year, with the alternating years seeing more targeted validation of any model components that have changed or that present a particular concern.

While it is natural for banks that recently have completed the transition to the CECL standard to focus on its immediate effects on the allowance, forward-looking boards and executive teams will broaden their perspectives to consider the new standard’s more far-reaching strategic and risk management implications. By understanding the drivers of the model and making sure they align with the perceived risks of the loan portfolio, banks can be better prepared to mitigate those risks. Furthermore, rather than focusing their attention on projected losses in isolation, bank leaders ultimately should take the additional information CECL offers them and apply this understanding to their broader organizational risk monitoring and risk management efforts.

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