Over the last 10 years, banks have discussed and debated the current expected credit loss, or CECL, accounting standard. Many of the larger banks adopted the standard in 2020, with the majority of smaller banks adopting on Jan. 1, 2023.
While the industry has adopted CECL, here are some items to consider in 2023 to position your institution for success in your next regulatory exam or external audit.
Prepare a CECL Adoption “Package”
When your regulators and auditors arrive in 2023, they will likely ask about your CECL implementation process. One way to address their questions is to prepare a package that includes:
- Board-approved allowance for credit losses, or ACL, policy.
- The initial adoption calculation.
- The consideration of unfunded commitments, which are recorded as a liability on the bank’s balance sheet, and debt securities, both available-for-sale and held-to-maturity.
- The bank’s narrative that supports its CECL calculation, which should include a summary of the selected model and methodology, assessment of qualitative factors and forecasting and a summary of any individually evaluated loans.
- The initial adoption journal entry, a reconciliation to your CECL calculation and documentation of a review and approval of the journal entry.
- Third-party vendor management documentation and CECL model validation.
Third-Party Vendor Management
If your bank is using a third-party vendor for its CECL calculation, be sure to document the vendor management considerations over this calculation annually in accordance with your bank’s vendor management policies and your primary regulator’s guidance.
Make sure this documentation includes procedures the bank has taken to gain comfort over the third party’s calculation, obtaining a service organization controls (SOC) report for the calculation and a CECL model validation for the third-party calculation. Your institution may need to get support from the vendor to assist with articulating the math behind the calculation and a recalculation of the ACL on an individual loan basis.
Perform Back Testing in 2023
As the bank’s CECL model “ages” in 2023, management should document back testing of the model to verify it is functioning as expected. Back testing can aid the bank in understanding the model and how estimates and varying economic results impact it.
As your bank develops its back testing procedures, consider comparing estimated data points to actual results, including prepayment speeds, loan charge-offs and recoveries, economic data points and loan balances. Additionally, management should consider sensitivity or stress testing of the model, including analysis of various scenarios or assumptions and their impact on loss estimates.
Add CECL to the 2023 Internal Audit Plan
The CECL model, like the historic incurred loss model, should be subject to the bank’s internal audit plan. This internal audit program can include reviewing the policies and procedures, gaining an understanding of the model, reviewing the assumptions in the model for reasonableness and consistency with other assumptions and reviewing the model access. It should also include procedures to verify calculations are appropriately reviewed by management and governance.
CECL Model Validation
As bank regulators discussed in the 2020 interagency policy statement on the allowances for credit losses, model validation is an essential element to a properly functioning process for a bank, and should be completed annually. Validation activities for a bank include evaluating and concluding on the conceptual soundness of the model, including developmental evidence, performing ongoing monitoring activities, including process verification and benchmarking and analyzing model output, according to the interagency statement.
The CECL model validation, which is a frequently overlooked part of CECL implementation, should be performed by an individual or firm that is independent from the model’s design, implementation, operations and ownership. Additionally, the interagency statement states the external auditor of the bank may impair independence if they also perform the CECL model validation.
The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, investment, or tax advice or opinion provided by CliftonLarsonAllen LLP (CliftonLarsonAllen) to the reader.
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