CECL Validations: Beyond the Numbers

Navigating the complexities of credit loss estimates

A seasoned auditor will be able to get a sense of whether your ACL is underfunded or overfunded with a back-of-the-envelope calculation. However, if you ask ten different auditors to use the same back-of-the-envelope method, there will likely be ten different figures. Those ten different figures will have a high, low, median, and an average. Simply stated, a range would be established. We might even be able to say if your ACL falls within this range that it is a reasonable figure. Now, substitute the back-of-the-envelope method with the WARM method. Take the same ten auditors and there will likely be ten different figures. Granted, this will be more calculation driven, but there still is judgement involved. Repeat the process with the Cumulative Loss Rate method. The point is, if you take the top six CECL methods (excluding the back-of-the-envelope method), and have ten different auditors, you could easily wind up with 60 different figures. So which one is right? We are credit union people. We like numbers. 2+2=4. How can there be 60 different figures that could be considered reasonable and appropriate?

Unfortunately, the answer is there can indeed be 60 different figures that are reasonable and appropriate. It is not exact science but rather an estimation involving several different types of assumptions. This can be infuriating to some people. A good way to bring the fury down and gain confidence in your process is to have a solid CECL policy in place. A robust CECL policy will not take away the fact that there are many, many different amounts that can be put into your allowance based on your methods of calculation and assumptions setting.

Key questions to address in the CECL policy

A comprehensive policy can allay the fears of how you arrive at the number you insert into your ACL. At a minimum, a CECL policy should answer the following basic questions:

1. Was there a discussion on which CECL model to use?
2. Who is running the model?
3. Is it a third party or done internally?
4. Who is monitoring the results?
5. How often is the CECL model being revisited?
6. Who is doing the revisiting?
7. Why did a certain model get chosen over another model?

These are all important questions to answer in your CECL policy. The CECL policy outlines a governance of the model and the decision-making process behind the model. Let’s revisit the back-of-the-envelope method. In this example, we will replace an experienced auditor with an experienced examiner. If an examiner eyeballs the ACL and sees it as a little too low for their comfort level, you will have your process documented to present as evidence to your decision making. Not only will you be able to defend the figure, but also the process on how you arrived at the figure. This is not to suggest the examiners are out there playing a game of “gotcha.” A veteran examiner who has been doing their job for 20 years is still learning the CECL methods, just like everyone else. The veteran examiner could have a sense of the ACL being underfunded at first glance. This may prompt a question to the ACL and CECL. 

Ensuring compliance through a CECL validation

This is where a CECL validation comes into the picture. A CECL validation service is essential for credit unions aiming to ensure compliance with the CECL accounting standard. This service offers a comprehensive review and validation of CECL processes, providing management with confidence that their methodologies are robust, compliant, and effective. By analyzing the methodologies used to estimate expected credit losses, a validation ensures that these approaches are appropriate for each credit union’s specific circumstances. This tailored service not only enhances the accuracy and reliability of CECL calculations but also provides actionable insights to address any discrepancies, ultimately strengthening your financial stability and performance.

Just as an ALM validation should not be done by the ALM model provider to avoid potential conflicts of interest, a CECL validation should be completed by a firm other than the firm performing the CECL calculations. Moreover, a CECL validation service should include a thorough review of governance frameworks, ensuring they support accurate and reliable CECL calculations. This involves assessing the roles and responsibilities of the CECL governance team and the effectiveness of internal controls.

QuantyPhi, Corporate Central Credit Union’s balance sheet optimization CUSO, has extensive experience performing validations on key credit union risk functions. By staying up to date with the latest regulatory changes and guidance, a CECL Validation provided by QuantyPhi helps credit unions navigate the complex compliance landscape with confidence. The service also includes an in-depth analysis of risk factors affecting the credit portfolio, ensuring all potential risks are accurately identified and assessed.