Independent Banker - August 2017 - 99

able to defend their models, " Newcomer
says.
Most banks feel the first CECL
filing will be a " best guess " and that
the entire industry will find ways
to improve on the process. After
all, the calculations banks will use
to estimate future losses are simply
estimations. The key is how they will
explain and defend their methodology
to analysts, examiners, board
directors and shareholders.
" To do this, they'll need to
effectively communicate how they
researched and decided which
methodologies to use in the models, "
Newcomer says. " If the reserves are
adjusted up or down 5 percent, they
will have to be able to explain why
and defend the results. "
Brett D. Schwantes, a CPA and
senior manager of the Wausau,
Wis., office of Wipfli LLP, says small
banks with accountants on staff
could potentially develop their own
models, avoiding having to pay for a
third-party solution.
" But just because a bank has the
resources to develop its own model
doesn't mean I recommend that it
automatically does this internally.
Other considerations need to go into
the decision, " Schwantes cautions.
" First, what happens if the CFO or
other employee maintaining the
model leaves or is out for extended
disability? Does the bank have someone
who can take over the CECL
responsibilities? If not, they are
going to be stuck. "
Simple methodologies
Another disadvantage of an in-house
model is a bank's likely adoption of a
simple methodology, which typically
results in larger allowances for loan
losses. The precision of a simple
methodology is much lower because
it does not include all the relevant
variables a more sophisticated methodology
could utilize.
" For example, with a simple
methodology, a bank is not going to
do not reflect the current credit quality
of the portfolio.
" The portfolio would likely have
improved a great deal after that,
but a simple methodology doesn't
account for that-it's stuck in 2012, "
Schwantes says. " That would result in
higher loan-loss reserves. "
On the other hand, if a bank hires
an outside party to develop a methodology
on its behalf, a more complex
and precise approach might be used,
such as the probability of default
methodology. This methodology uses
statistical analysis to calculate the
probability of each loan defaulting
and then estimates how much loss the
bank would incur as a result of that
individual default.
Another more complex methodology
that might be used is the
discounted cash-flow methodology,
Schwantes says. This methodology
schedules all of the monthly payments
for each loan using scheduled
consider probability of default for
each individual loan but instead will
only be looking at the entire portfolio, "
Schwantes says. He adds that a
simple methodology may not consider
changes in risk characteristics of the
portfolio over time; thus management
will have to spend more time determining
qualitative adjustments to the
calculated CECL loss rate.
If a bank today used a five-year
life to calculate the cumulative loss
rate of its portfolio, the bank would
be going back to 2012, when it might
have been taking losses on its loans
due to fallout from the recession that
" Banks can buy or
build models, but no
matter what, they
need to be able to
defend their models. "
-WILL NEWCOMER,
WOLTERS KLUWER
payments and other factors, such as a
constant default rate and an estimate
for prepayments, then discounts the
cash flows back to the current period
using the loan's effective rate.
Many banks may also opt to use
different methodologies for different
loan types. " If a particular pool is not
material-say, a bank doesn't make
many auto loans-then they might
not want to spend the money on a
complex methodology but instead
use a simpler methodology for that
pool, " Schwantes explains.
Data decisions
After determining the type of
methodology they'll use, community
banks then need to assess the type
of data they'll need. Basic data for
all methodologies include the loan
trial balance and loan-specific information,
such as origination dates,
origination balance, charge-off and/
or recovery dates and amounts.
If further information is required
for the model, Schwantes advises
banks to involve their loan processing
staff to determine what kinds of
additional data they might have to
start collecting at the time of origination,
as well as throughout the life of
the loan.
" For example, banks might want
to start collecting data on the pastdue
status for each loan, including
whether the loan is past due for 30
days, 60 days or 90 days, " Schwantes
says. " The bank might also want to
track how often each loan is past due
and then develop a process to make
sure the system is updated regularly. "
Bruce Richter, a CPA, CMA, CIA,
CFE and senior manager at Eide
Bailly LLP in Mankato, Minn., recommends
community banks consider
a " vintage analysis " model. This historical
loss approach analyzes loans
grouped by " vintage, " meaning the
year they were originated.
" The vintage approach tracks the
life of a loan throughout its life cycle,
and the data needed is going to be
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