CECL Reserve Adequacy: How One Institution Tells Its Best Story

CECL

In our ongoing conversations with bank and credit union clients, DCG is observing an emerging theme in regulatory feedback regarding CECL models.

As the industry moves through economic inflection points, regulators are reminding institutions that they must continuously confirm that their reserve for credit losses is adequate – and that it remains so as conditions evolve. However, most institutions struggle to both successfully monitor their reserve as well as fully communicate their best story to external and internal stakeholders.

The following six steps are a live example of how one institution approaches this challenge using DCG’s CECL Ongoing Performance Monitoring Report.

Step 1: Perform Level and Trend Analysis

Comparing an institution’s allowance with both peer group and national averages can help contextualize its risk appetite and identify red flags. It is important to highlight and explain differences – for example, changes in loan mix or any ebbs/spikes in loss history. 

In this example, the institution holds higher reserves than its peer average (geographic and asset size) and the national average. It has also increased reserves much faster than its peer group average while the national average has not increased. This indicates that there may be something disadvantageous happening that should be explained to stakeholders.

Source: DCG Ongoing Performance Monitoring Report client example

Step 2: Monitor Credit Quality Trends

Monitoring credit quality trends helps institutions identify emerging risks and deterioration in borrower creditworthiness before losses are realized.

In this example, the institution has historically outpaced peer and national averages for negative credit quality trends, with higher net charge-offs, higher nonaccruals, and higher severe delinquencies. The reserve, given its history, should be higher on a level basis because the institution has always accepted more risk in its portfolio. In recent periods, peer and national metric averages rose but at a much slower pace than the institution’s recent experience.

Source: DCG Ongoing Performance Monitoring Report client example

Source: DCG Ongoing Performance Monitoring Report client example

Source: DCG Ongoing Performance Monitoring Report client example

Step 3: Compare Portfolio Mix

Institutions must be able to quantitatively determine whether their loan mix is more (or less) risky than the industry loan mix. Comparing historical industry loss rates by portfolios to an institution’s loss history can provide broad insight regarding management’s loan underwriting relative to peers. The comparison is more than just a benchmark; it can directly impact how an institution estimates, models, and justifies credit losses.

In this example, the higher risk in the institution’s portfolio is evident based on the mix between asset classes. As compared to the average institution, it holds 50% more non-RE consumer loans. The looming question is, do they have enough in reserves to cover this business strategy?

Source: DCG Ongoing Performance Monitoring Report client example

Step 4: Review Coverage Ratios

The level of an institution’s nonaccrual loans and past due loans are central to its reserve adequacy story. Coverage ratios can help demonstrate whether existing reserves are sufficient for potential losses; if reserves cannot cover nonaccrual and severely delinquent loans, asset quality problems and increased regulatory scrutiny are more likely.

In this example, for those credits most likely to experience loss (Nonaccruals), current reserves are sufficient (ratio > 1).

Source: DCG Ongoing Performance Monitoring Report client example

The Past Due Coverage ratio provides a more forward-looking glimpse into future asset quality and monitoring it can reveal important insights into the current industry credit cycle. Unlike the Non-Current Coverage ratio, this ratio will not always be over 1.0, and the delinquency of a few large loans might periodically reduce it. In fact, when there is a credit downturn, the peer and national averages will be below 1.0.

In this example, for all delinquent credits, the current reserve level provides less coverage than peers and the national average (0.42 < 0.59 < 0.62).

Source: DCG Ongoing Performance Monitoring Report client example

Is that acceptable to stakeholders? Does the institution have internal analysis to demonstrate the roll rate of delinquencies? This is where drilling in using internal data can round out the story. For example, if most of the institution’s delinquent credits are indirect used auto, missing one payment may be a negative sign for the overall health of the loan. But if the delinquent credits are other secured lending, missing one payment may not be critical and missing two or more may be the real trigger (so a coverage ratio of ACL / 60+ dpd is a better indicator). Management should be prepared to explain this.

Step 5: Determine Capacity to Withstand Adverse Scenarios

The ultimate check on adequacy is capital resiliency, i.e., how much capital the institution can use should expected losses over a reasonable and supportable forecast be realized. Using a scenario-based methodology allows management to evaluate overall sensitivity. Many institutions find that expected credit loss sensitivity analysis is particularly useful in telling their best reserve story.

In this example, even in the most extreme case (Fed Severely Adverse), the institution has enough capital to stay above regulatory thresholds.

Source: DCG Ongoing Performance Monitoring Report client example

Step 6: Draw Conclusions

The optics of reserve levels and trends lead regulators/auditors/stakeholders to draw conclusions about institutional health. It is a dynamic and continuously unfolding story that banks and credit unions must tell.

In this example, we saw that the institution is quickly building reserves… does it mean trouble? Typically, when credit risk is threatening earnings and capital, management needs to start making balance sheet decisions, if it hasn’t already. But when this institution is armed to tell its story well, it turns out that it is in a stable position: metrics are higher because they should be higher, and coverage is adequate today.

However, this management team knows that things change every day, and they rely on their ongoing performance monitoring framework to keep abreast of potential adverse scenarios on the horizon.

Get a Complimentary Consultation on Your Number

DCG designed the quarterly CECL Ongoing Performance Monitoring Report to assist institutions telling their reserve adequacy story. We invite you to request a sample report customized with your institution’s data to confirm your reserve adequacy. 

We are confident that you will find the report valuable, and that you will be better equipped to tell your best story to external and internal stakeholders.

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To learn more about Ongoing Performance Monitoring for CECL and receive a complimentary sample report featuring your institution’s data, contact the DCG CECL team.

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ABOUT THE AUTHOR

J. Chase Ogden is a Quantitative Consultant with Darling Consulting Group's Quantitative Risk Analysis and Strategy team. As a practitioner at large and mid-sized financial institutions, Chase has experience in a wide array of modeling approaches, applications, and techniques, including asset/liability models, pricing and profitability, capital models, credit risk and reserve models, operational risk models, deposit studies, prepayment models, branch site analytics, associate goals and incentives, customer attrition models, householding algorithms, and next-most-likely product association. 

Chase is a graduate of the University of Mississippi and holds master’s degrees in international commerce policy and applied statistics from George Mason University and the University of Alabama, respectively. A teacher at heart, Chase frequents as an adjunct instructor of mathematics and statistics.

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