Does Individual Review Still Apply in a CECL World?
With all the talk of static pool, vintage, probability of default, and discounted cash flow, you might be wondering if you should still review loans (or any financial asset subject to CECL for that matter) on an individual basis. While the focus of CECL is clearly on collective review, the short answer is, yes, individual review still applies but with some overt or implied changes.
When should you review loans on an individual basis?
Loans should be reviewed on an individual basis when they do not share similar risk characteristics with a suitable pool of loans. Simple enough, right?
The accounting standard update states that, “An entity shall evaluate whether a financial asset in a pool continues to exhibit similar risk characteristics with other financial assets in the pool. For example, there may be changes in credit risk, borrower circumstances, recognition of write-offs, or cash collections that have been fully applied to principal on the basis of non-accrual practices that may require a reevaluation to determine if the asset has migrated to have similar risk characteristics with assets in another pool, or if the credit loss measurement of the asset should be performed individually because the asset no longer has similar risk characteristics.” (326-20-35-1)
However, the update also states that, “There is no requirement to evaluate financial assets individually when a certain level of credit deterioration has occurred.” (326-20-55-32) There is also no requirement to analyze troubled debt restructured (TDR) loans on an individual basis.
Summarizing, if a loan doesn’t fit nicely into a suitable pool of loans for any reason, or if it has changes in credit risk, borrower circumstances, recognition of write-offs, or cash collections, then it is a candidate for individual review, but the overarching principle to consider is whether the loan shares similar risk characteristics with an applicable pool or not.
How do you review loans on an individual basis?
The two methods most institutions currently use to analyze loans on an individual basis are discounted cash flow and fair value less cost to sell, with the latter being required for collateral-dependent loans and/or if foreclosure is probable. These methods will still be applicable in CECL; however, the resulting allowance should cover life of the loan estimates, and historical, current, and reasonable and supportable forecasted conditions should be considered. These methods were highlighted in illustrations provided in the accounting standards update.
An example of a “new” method also highlighted in the update details a simple adjusted loss rate method. In this example, a $1 M commercial loan was reviewed on an individual basis using a proxy loss rate (from peer data) and an adjustment for environmental factors.
- Amortized Cost Basis: $1,000,000
- Base Loss Rate: 0.5% (based on peer data)
- Economic Adjustment: 0.1% (based on management judgment)
- Allowance for Expected Credit Loss: $6,000 ($1,000,000 x .05 x .01)
Given these examples, in addition to other statements in the accounting standards update, a wide range of methods can be deployed to individually review loans, including discounted cash flow, fair value less cost to sell, adjusted loss rate (peer), probability of default, etc. However, the method either needs to implicitly or overtly consider the remaining life of the loan and a broad range of information including historical, current, and forecasted conditions.