Pub. 6 2017 Issue 3

17 f a l l | 2017 Ironically, while smaller banks are in better position to benefit from CECL from a technical perspective, they will struggle the most with implementation due to a general lack of sophistication and the relative cost of using third-party tools. the “life of a loan” concept underpinning CECL. The Invictus stress testing system is uniquely qualified to perform this analysis because the methodology is consistent with the main CECL principles: loan portfolio segmentation, vintage analyt- ics, expected loss modeling and risk rating migration patterns. There are several logical reasons why smaller banks should be less exposed to CECL, as revealed by the analysis: • Smaller banks tend to be more over-reserved since many are privately-held and do not have the pressure of meeting quarterly earnings estimates • More than 90 percent of a bank’s loan loss reserve today is derived from qualitative factors. Since charge-offs in the industry have significantly declined over the last three years, banks simply do not have a meaningful history of losses on which to build an adequate loan loss reserve. As a result, CFOs are forced to depend more on these qualitative factors – which are supposed to be a proxy for the forward-looking component of the existing ALLL – and simply guess. These factors are essentially a de facto CECL placeholder estimate. What CECL will do is replace the guesswork with analytics, leading to lower loan loss reserves for many banks. • Smaller banks tend to be more focused on real estate loans, which are actually less risky than the C&I and consumer loans that tend to represent a greater portion of a bigger bank’s balance sheet. This difference is exacerbated by the reduced exposure of small banks to construction loans since the financial crisis. Ironically, while smaller banks are in better position to benefit from CECL from a technical perspective, they will struggle the most with implementation due to a general lack of sophistica- tion and the relative cost of using third-party tools. Banks should determine what additional data they need down the line, and devise a plan to adjust their business processes to collect it dynamically. That entails rethinking loan classifica - tion systems and their portfolio segmentations. As the FDIC noted in a Financial Institution Letter in Decem- ber, “CECL allows institutions to apply judgment in develop- ing estimation methods that are appropriate and practical for their circumstances.” Thought leadership on how banks adapt CECL will be re- warded. Banks should be aggressive on data gathering, but should avoid buying a black-box solution. A CECL system can be simple; don’t believe the hype that it has to be complex. The best way to prepare for CECL is to start small, and build out. Believe it or not, most banks have the ability to run a very simple CECL analysis, even now. The key is to segment the portfolio properly. Mock calculations can then be performed on each segment. The assumptions driving the model might not be 100 percent accurate, but at least this gives a starting point to determine what additional data is needed. As you get more data, you run more mock calculations until you get it right. That would enable your bank to evolve its calculations by the time CECL is implemented. The worst thing you can do is try to build a perfect system on Day One. That is what will lead to wasted time and money. In the end, CECL is not only about compliance. It’s also about maximizing shareholder value, strategic planning, capital planning and M&A. CECL will change the way investors view a bank’s balance sheet. Smart banks will want to know what that picture looks like—and how they can optimize their bank for implementation. Adam Mustafa is the president of the Invictus Group, a data-driven strategic advisory firm that specializes in M&A, CECL readiness, stress testing and capital planning. https://www.fdic.gov/news/news/financial/2016/fil16079a.pdf - Address of FDIC December FIL F E A T U R E