CECL – Using a Reasonable and

Supportable Forecast
July 2019
Speakers

Chris Henkel Robby Holditch Sohini Chowdhury

Senior Director, Director, Regulatory and Director, Regulatory and
Enterprise Risk Solutions Accounting Solutions Accounting Solutions
Moody’s Analytics Moody’s Analytics Moody’s Analytics

CECL – Using a Reasonable and Supportable Forecast 2

Today’s Discussion Points

» CECL Overview: What’s Changing?

» Recent Updates: Real-life Impact

» Estimating Expected Credit Losses (“ECL”): A Refresher

» Understanding and Defending Your Reasonable and Supportable Forecast

» Concluding Remarks and Q&A

CECL – Using a Reasonable and Supportable Forecast 3

1 CECL Overview
What is CECL
FASB, ASU No. 2016-13, June 2016
Financial Instruments—Credit Losses (Topic 326)

CECL means CURRENT EXPECTED CREDIT LOSS Lifetime loss

estimate from origination which replaces “incurred loss” model,
where:

“The measurement of expected credit losses is based on relevant information

about past events, including historical experience, current conditions, and
reasonable and supportable forecasts that affect the collectability of the
reported amount. An entity must use judgment in determining the relevant
information and estimation methods that are appropriate in its circumstances.”

CECL – Using a Reasonable and Supportable Forecast 5

Changes Under CECL
Applies to all banks, savings associations, credit unions

» Scope: financial instruments measured at amortized cost basis

– Loans held for investment
– Debt securities held to maturity
– Debt securities available for sale*
– Off balance sheet exposures (Loan commitments, Letters of Credit)
» Measure expected credit losses over the life of financial asset based on:
– Past events, including historical experience
– Current conditions
– Reasonable and supportable forecasts
» New and changing GAAP Disclosure requirements: amortized cost by credit
quality indicators and vintage, collateral dependent loans and PCD disclosure
*Credit losses are recorded through the allowance and can be reversed. Allowance is subject to FV floor. Holding gain/loss – OCI. AFS security’s Am Cost is
written down to FV only if Am Cost<FV and the institution intends to sell or more than likely will be required to sell.

CECL – Using a Reasonable and Supportable Forecast 6

Summary

Your CECL Formula =

Adjustments
Adjustments for
Historical for Current
or or Reasonable
loss Economic
experience &
Conditions Supportable
Forecast*

*326-20-30-9 - An entity is not required to develop forecasts over the contractual term of the financial asset or group of financial assets. Rather,
for periods beyond which the entity is able to make or obtain reasonable and supportable forecasts of expected credit losses, an entity shall
revert to historical loss information.

CECL – Using a Reasonable and Supportable Forecast 7

Defining What is Acceptable…
There are a few elements that are required to be incorporated when using any methods…

326-20-30-9 An entity shall not rely solely on past events to estimate

» Historical Information expected credit losses…. When an entity uses historical loss
information, it shall consider the need to adjust historical
information to reflect the extent to which management expects
reasonable and supportable forecast…….The adjustments to
» Current conditions historical loss information may be qualitative in nature and should
reflect changes related to relevant data …..

326-20-30-9 Con’t……… Some entities may be able to develop

» Reasonable & Supportable Forecast reasonable and supportable forecasts over the contractual term of the
financial asset or a group of financial assets. However, an entity is not
required to develop forecasts over the contractual term of the
financial asset or group of financial assets. Rather, for periods beyond
» Reversion to long term averages which the entity is able to make or obtain reasonable and supportable
forecasts of expected credit losses, an entity shall revert to historical
loss information

» Expert Judgement

CECL – Using a Reasonable and Supportable Forecast 8

New disclosure requirements!
326-20-50-11 An entity shall disclose all of the following by portfolio
segment and major security type:

a) A description of how expected loss estimates are developed

b) A description of the entity’s accounting policies and methodology

to estimate the allowance for credit losses, as well as a
discussion of the factors that influenced management’s current
estimate of expected losses, including:
1) Past Events
2) Current Conditions
3) REASONABLE AND SUPPORTABLE FORECAST

…as CECL nears, look for new and changed

disclosures from FASB, SEC, and regulatory bodies…

CECL – Using a Reasonable and Supportable Forecast 9

From AICPA Banking Conference 2018

“ CECL is sensibly designed…

Prepares need to present economic assumption,

”
perhaps in a tabular format….
SEC Remarks at the 2018 AICPA Banking Conference

CECL – Using a Reasonable and Supportable Forecast 10

Economic Assumption Tabular Example

Moody’s Example

CECL – Using a Reasonable and Supportable Forecast 11

2 Recent Updates
Potential Timeline Changes
» There are currently 4 initiatives underway that could alter the timeline for the
implementation of CECL. All 4 are being actively monitored but could yield
changes to the implications of the new standard.

» Those in House and Senate are in committee and require committee chairs to
agree to put them on the agenda

» Current feeling is that the House Finance committee chair (Rep. Waters D-
CA) does not have an appetite to take this on.

» Potential motivating factors are emerging:

» House bill has bi-partisan support and may be used to showcase this
» There are similar bills in both the House and Senate

» FASB has introduced through their Private Company Council a possible

compromise that would push back the effective date for 1/1/2021 filers to
1/1/2022 (coincides with credit unions, non-profits, and small banks).

CECL – Using a Reasonable and Supportable Forecast 13

 Issuer Legislation Summary Status
FASB Private Company Council The PCC within the FASB is considering a The implication is that this
(PCC) proposal for change within it’s standard issuance process would push the non-SEC
effective date changes that would make the effective date on new filing PBE’s (many mid-
guidance a standard 2 years after public sized banks) to a 1/1/2022
Introduced: June 2019 companies. effective date for CECL
from the current 1/1/2021.
Possible change was well
accepted by the FASB and
is being discussed further.
US Senate Continued AKA the ‘Stop and Study’ bill would require Introduced in the Senate
Encouragement for FASB to halt implementation of CECL and by Thom Tillis (R-NC).
Consumer Lending Act (S. conduct a quantitative study to determine the Referred to Committee on
1564) standard’s impact Banking, Housing and
Urban Affairs.
Introduced: May 2019
US House of CECL Consumer Impact Similar parameters to Senate bill requiring a Introduced by Rep.
Representatives and Study Bill of 2019 halt to implementation of CECL until further Gonzalez (D-TX).
(H.R. 3182) study can be done. Moved to Committees
(Financial Services and
Introduced: June 2019 Agriculture).
US House of Prohibit regulators from Directly from bill: “To prohibit the Federal Introduced by Rep.
Representatives requiring CECL financial regulators from requiring compliance Luetkemeyer (R-MO).
compliance with the accounting standards update of the Moved to Committees
(H.R. 7394) Financial Accounting Standards Board related (Financial Services and
to current expected credit loss ("CECL")…” Agriculture).
Introduced: Dec. 2018 Bill includes SEC from requiring compliance.

CECL – Using a Reasonable and Supportable Forecast 14

Regulatory Capital Changes
NR 2018-142
FOR IMMEDIATE RELEASE
December 21, 2018

Agencies Allow Three-Year Regulatory Capital Phase In for New Current Expected Credit Losses (CECL) Accounting
Standard

The federal bank regulatory agencies approved a final rule modifying their regulatory capital rules and providing an option to
phase in over a period of three years the day-one regulatory capital effects of the update to the accounting standard known
as the “Current Expected Credit Losses” (CECL) methodology. The final rule also revises the agencies’ other rules to reflect
the update to the accounting standards.

CECL – Using a Reasonable and Supportable Forecast 15

Proposed Changes to Call Report FFIEC 031, 041 & 051
Draft Reporting Form Call Report Revisions Proposed

This draft reporting form reflects revisions addressing the revised accounting for credit losses under the
Financial Accounting Standards Board’s Accounting Standards Update No. 2016-13, “Financial Instruments –
Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments”

1) April 2019 Proposed Call Report Revisions for the Community Bank Leverage Ratio to RC-R
2) September 2018 Proposed Call Report Revisions to RI-B & RI-C

CECL – Using a Reasonable and Supportable Forecast 16

3 Estimating Expected Credit
Losses (“ECL”): A Refresher
Common Methodologies to Estimate Credit Loss
» Loss Rate
– Pool/cohort approach
– Rating and loan type
– “WARM” method

» Probability of Default (“PD”) and Loss Given Default (“LGD”)

– Mapping internal ratings to agency ratings
– Use internal rating distribution and a central tendency of default
› Improve granularity with a PD (LGD) model
– Build or buy PD/LGD scorecards as part of a “dual risk ratings” framework
An institution may apply different estimation methods to different groups of financial assets. However, to properly apply an
acceptable estimation method, an institution’s credit loss estimates must be well supported
CECL – Using a Reasonable and Supportable Forecast 18
Solving the Data Problem
A sensible way to think about it…

How should I segment my portfolio? Which methodologies are appropriate? Where can I find the data I need?

CECL – Using a Reasonable and Supportable Forecast 19

Regardless of the approach, you will need three types
of data to derive CECL estimates

1. Data that captures the segment/pool’s

historical loss experience

2. Data for adjusting historical loss data to

reflect the current credit environment on
instruments in the segment/pool Data can be used to model ECL
quantitatively or to support
qualitative adjustments
3. Data for incorporating the impact of
economic forecasts on instruments in the
segment/pool
You may also require data to support prepayments and other assumptions
CECL – Using a Reasonable and Supportable Forecast 20
Loss Rate Method Example
A group of loans have an amortized
cost of $5M at the end of 2015.

Year Amortized Cost Average Balance Observed NCOs

2015 $ 5,000
2016 $ 5,500 $ 5,250 $ 20
2017 $ 6,000 $ 5,750 $ 50
2018 $ 6,500 $ 6,250 $ 40
2019 $ 7,000 $ 6,750 $ 30
2020 $ 7,500 $ 7,250 $ 50
During 2016-2020, $190K of the
2015 Pool's Cumulative NCOs $ 190 $5M are charged off (includes
Lifetime Historical NCO (unadjusted) 3.80% recoveries), resulting in a
cumulative loss rate of 3.80%.
Qualitative Adjustment 0.25%
After qualitatively adjusting for the
Total ACL (%) as of 2020 4.05% effects of current conditions and
Total ACL ($) as of 2020 $ 304 economic forecasts, we arrive at a
cumulative loss rate of 4.05% to be
applied to the amortized cost of the
pool at the end of 2020 – resulting
in an allowance of $304k. .

CECL – Using a Reasonable and Supportable Forecast 21

 PD and LGD Method
Commercial Real Estate Loan Commercial & Industrial Loan
Quantitative Quantitative
Qualitative Factors Qualitative Factors
Factors Factors

Master Rating Scale

Quantitative Risk Qualitative Score Quantitative Risk Qualitative Score
Measure (EDF%) (0–100) Rating Rating Measure (EDF%) (0–100)
PD (1 Year)
Grade Grade
1 0.08% 1
Total Score 2 0.14% 2 Total Score

3 0.25% 3
4 0.43% 4
5 0.75% 5
Borrower 6 1.31% 6 Borrower
Rating 7 2.30% 7 Rating
8 4.02% 8
9 7.04% 9
Consistent grades across
What information would be required? 10 12.31% 10 the entire loan portfolio
… … …

CECL – Using a Reasonable and Supportable Forecast 22

Example of a PD and LGD Rating Scale

A B C D E F G
5% 15% 20% 25% 35% 45% 55%
1 Pass 0.08% 0.00% 0.01% 0.02% 0.02% 0.03% 0.04% 0.04%
2 Pass 0.14% 0.01% 0.02% 0.03% 0.04% 0.05% 0.06% 0.08%
3 Pass 0.25% 0.01% 0.04% 0.05% 0.06% 0.09% 0.11% 0.13%
4 Pass 0.43% 0.02% 0.06% 0.09% 0.11% 0.15% 0.19% 0.24%
5 Pass 0.75% 0.04% 0.11% 0.15% 0.19% 0.26% 0.34% 0.41%
6 Pass 1.31% 0.07% 0.20% 0.26% 0.33% 0.46% 0.59% 0.72%
7 Pass 2.30% 0.11% 0.34% 0.46% 0.57% 0.80% 1.03% 1.26%
8 Pass 4.02% 0.20% 0.60% 0.80% 1.01% 1.41% 1.81% 2.21%
9 Pass 7.04% 0.35% 1.06% 1.41% 1.76% 2.46% 3.17% 3.87%
10 OAEM 12.31% 0.62% 1.85% 2.46% 3.08% 4.31% 5.54% 6.77%
11 Substandard - A 20.00% 1.00% 3.00% 4.00% 5.00% 7.00% 9.00% 11.00%
12 Substandard - NA 35.00% 1.75% 5.25% 7.00% 8.75% 12.25% 15.75% 19.25%
13 Doubtful 50.00% 2.50% 7.50% 10.00% 12.50% 17.50% 22.50% 27.50%
14 Loss 100.00% 5.00% 15.00% 20.00% 25.00% 35.00% 45.00% 55.00%

CECL – Using a Reasonable and Supportable Forecast 23

Asset Quality Statistics
Noncurrent loans are well below the …therefore so are the amount of loans
long-run average… being charged-off

Noncurrent Loan Rate Annual Net Charge-Off Rate

5.00% 2.50%
4.50%
4.00% 2.00%
3.50%
3.00% 1.50%
2.50%
Avg. 1.59% 2.00% 1.00%
Avg. 0.66%
1.50%
1.00% 0.50%
0.50%
0.00% 0.00%

Source: FDIC (all insured institutions $1B to $10B in total assets)

CECL – Using a Reasonable and Supportable Forecast 24

Food for Thought…

It is acceptable to adjust historical loss information for current

conditions and the reasonable and supportable forecasts
through a qualitative approach rather than a quantitative
approach…but is it really easier?

Small changes to “Q Factor” assumptions may result in large

changes to credit loss provisions, potentially inviting greater
scrutiny from auditors, examiners, and bank board members.

CECL – Using a Reasonable and Supportable Forecast 25

4
Understanding and Defending
“Reasonable and Supportable”
(R&S) Forecasts
CECL Forecasting Requirements
Topic 326 guidance
“The measurement of expected credit losses is based on relevant
information about past events, including historical experience, current
conditions, and reasonable and supportable forecasts that affect the
collectability of the reported amount. An entity must use judgment in
determining the relevant information and estimation methods that are
appropriate in its circumstances.”

Source: Page 3, Financial Instruments—Credit Losses (Topic 326), FASB, No. 2016-13,
June 2016

CECL – Using a Reasonable and Supportable Forecast 27

3 Ways of Satisfying the R&S Requirement

1. Reversion in inputs
Revert to unadjusted historical average economic values
R&S period < life of
the loan
2. Reversion in outputs
Revert to unadjusted historical average losses

3. Lifetime R&S
R&S period = life of the loan

CECL – Using a Reasonable and Supportable Forecast 28

How to Incorporate Economic Forecasts in CECL?
CECL does NOT require a specific approach
 Qualitatively leveraging the forecasts acceptable for smaller institutions
 No strict rules on number of scenarios, weights etc. But,
– Using multiple scenarios mitigates the uncertainty from a single forecast
– Controls for the non-linearity in credit losses
– Provides guidance regarding sensitivity of losses to economic
slowdown/downturn

CECL – Using a Reasonable and Supportable Forecast 29

R&S Shorter Than Life of the Loan
Elect an R&S period, a reversion period and a reversion technique.
Reversion to unadjusted historical averages can be –

1. IN INPUTS

Over R&S period = Economic forecasts using the model

Over reversion period = Economic forecasts artificially revert to unadjusted
historical averages
After reversion period until the end of life = Economic forecasts set equal to
unadjusted historical averages

Estimate lifetime loss using this economic forecast as input into credit loss model
CECL – Using a Reasonable and Supportable Forecast 30
Input Reversion Example
Unemployment rate, %, US

10.0
Lookback Period = 20 qtrs.
9.0 Historical Unadjusted Average = 5.2%
8.0 R&S Period = 8 qtrs.
7.0
Reversion Period = 4 qtrs.
Reversion Technique = Straight Line
6.0
5.0
4.0
3.0

Moody's Analytics Baseline User Defined

CECL – Using a Reasonable and Supportable Forecast 31

R&S Shorter Than Life of the Loan
2. IN OUTPUTS

Over R&S period = Credit loss and economic forecasts using the model
Over reversion period = Credit losses artificially revert to some unadjusted
historical average
After reversion period until the end of life = Credit losses set equal to
unadjusted historical averages

CECL – Using a Reasonable and Supportable Forecast 32

Output Reversion Example
Monthly Loss Rate, %

0.20

0.15

0.10

Model-determined over 3yrs R&S period

0.05 Historical Unadjusted Loss Rate
Immediate Reversion
Gradual Reversion over 1yr
0.00
1 13 25 37 49
Age of loan (months)
For illustration purposes only
CECL – Using a Reasonable and Supportable Forecast 33
R&S = Life of the Loan
3. LIFETIME R&S

Possible only if BOTH a) and b) are satisfied

a) Economic forecasts are R&S over the life of the loan
b) Credit loss models produce reasonable estimates of losses over the life
of the loan

CECL – Using a Reasonable and Supportable Forecast 34

What Makes an Economic Forecast R&S Over Lifetime?
It is produced by a model which:

is based on sound, generally accepted economic theory

incorporates inter-relationships and feedback effects
• a shock to one factor impacts all other factors over time
considers a range of possible outcomes
provides info at varying levels of geography & captures local economic effects
utilizes a rigorous, auditable process for data and forecasting
AND...
Converges to historical trends in the long run
Moody’s Economic Forecasts are R&S over Lifetime!!
CECL – Using a Reasonable and Supportable Forecast 35
Structural Forecast Model: Set of Interlinked Equations
The approach used by Federal Reserve, IMF, Central Banks, and Moody’s Analytics

10-yr yield
Consumption Wages and salaries
Banking sector

Investment Labor force

Monetary policy rate
Government Employment

Population
Prices Exchange rates Exports Unemployment rate

Import prices Imports

GDP
Potential GDP
Global prices
Global GDP

CECL – Using a Reasonable and Supportable Forecast 36

Integrated National, State, and Metro-Level Forecasts
Unemployment rate, %
12
National State
10

8
2019Q1 F
6

2 Metro

0
00 02 04 06 08 10 12 14 16 18 2019Q1 F

CECL – Using a Reasonable and Supportable Forecast 37

Moody’s Forecasts Cover a Range of Possible Outcomes
Scenario Inventory
US Real GDP, % change annualized BL Baseline Forecast (50th pctile)
8 CB Consensus Baseline
7 S0 Strong Upside (4th pctile)
6 S1 Stronger Near-Term Growth (10th pctile)
5 S2 Slower Near-Term Growth (75th pctile)
4
S3 Moderate Recession (90th pctile)
3
2
S4 Protracted Slump (96th pctile)
1 S5 Below-Trend Long-Term Growth
0 S6 Stagflation
-1 S7 Next-Cycle Recession
-2
S0 Baseline
S8 Low Oil Price
-3 CS Constant Severity
-4 S1 S3
CB Consensus Baseline
-5 S4
-6
18 19 20 21 22 23 24 25 26 27 28 29 30 FB Fed Baseline
FA Fed Adverse
Source: Moody’s Analytics FS Severely Adverse Scenario
BC Bank-Specific Scenario
CECL – Using a Reasonable and Supportable Forecast 38
Which R&S Approach Should You Use?
Each has its pros and cons
R&S Approach PROS CONS
Reversion in Inputs or – Need economic forecast only – Have to defend choice of R&S period
Outputs through R&S period – Have to defend choice of lookback period used
(R&S period < life of loan) – Need credit loss model to for calculating unadjusted historical averages
produce defendable forecasts – In output reversion, portfolio-specific lookback
only through R&S period period will be harder to defend
– Harder to validate and monitor
– Input reversion might underestimate provisions

Lifetime R&S – Easier to interpret, monitor – Might underestimate provisions in certain cases
and validate a forecast – Requires economic forecasts which are R&S
coming out of a single model through life of the loan
– Convergence is to a historical – Requires credit loss models which produce valid
trend which is intuitive and results through life of the loan
model-determined

CECL – Using a Reasonable and Supportable Forecast 39

5 Concluding Remarks
and Q&A
CECL – Using a Reasonable and Supportable Forecast 41
Robby Holditch Chris Henkel
Director Senior Director
+1 (212) 553-2119 +1 (212) 553-4679
[email protected] [email protected]

For more info on Moody’s Analytics solution, visit our CECL site:
http://MoodysAnalytics.com/CECL-implementation
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direct or compensatory losses or damages caused to any person or entity, including but not limited to by any negligence (but excluding fraud, willful
misconduct or any other type of liability that, for the avoidance of doubt, by law cannot be excluded) on the part of, or any contingency within or beyond the
control of, MOODY’S or any of its directors, officers, employees, agents, representatives, licensors or suppliers, arising from or in connection with the
information contained herein or the use of or inability to use any such information.

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