Among the many decisions financial institutions will need to make in order to comply with the new CECL Accounting Standard Update (ASU), one of the most important is determining which method to use to estimate expected credit losses on loans and other assets measured at amortized cost.
This ASU references loss rate methods, probability or default methods, and discounted cash flow methods, but how do you know which method is most appropriate for your institution? In this white paper, industry experts offer a guide to help you make the best decision for your financial institution.
Factors to consider include:
- Feasibility: Review your data quality and completeness on a pool level. This will help determine which methodologies are feasible. Some methods may not be feasible if certain required data is limited or unavailable.
- Performance: Backtest each method. This is accomplished by estimating the allowance on a historical data set and comparing the results to actual losses for a comparable period. Backtesting should be performed on various data dates for a variety of methods and settings.
- Management Judgement: Consider management’s experience and judgement. Management should carefully consider advantages and disadvantages of each method, their assumptions and limitations for its use, and the sustainability of preparers using a particular method.
Possible methods to select:
- Static Pool: This method requires only simple mathematical calculations. It is meant to resemble a traditional lookback loss rate. When a class of loans is multiplied by the current balance of the class, the rate is equal to the balance expected to be collected due to credit loss.
- Vintage: The Vintage method is useful if you like the concept of a loss rate but prefer to make fewer assumptions than required for the Static Pool method. Another advantage of the Vintage method is that is accounts for loan age. Note that a seasoned loan generally carries less risk than newer loans, however, the level of seasoning in a portfolio can change drastically over time.
- Advanced Vintage: Like the Static Pool and Vintage CECL methods, the Advanced Vintage method is a type of loss rate method. For this method, use a rate that represents the percentage of a balance expected to not be collected.
- Probability of Default: The Probability of Default (PD) method uses a fundamentally different approach than the Vintage or Static Pool methods. Rather than producing a rate to multiply by the current balance, the PD method leveraging loan and economic factors to produce monthly projections of credit loss.
- Discounted Cash Flow with Probability Default: The Discounted Cash Flow with Probability of Default (DCF-PD) method uses many of the same components as the PD method but utilizes a different framework. Monthly probabilities of default and prepay are both produced with the discrete time survival models. Instead of applying them with LGD, they are used to estimate future monthly cash flows.