Our favorite time of the year has arrived – March Madness! Perhaps you joined Visible Equity’s Tournament Challenge to show off your college basketball analytics skills. Is your bracket busted yet? If you successfully picked the Sweet Sixteen, you must have a pretty good strategy going for you.
As the Product Director for CECL, trying to make the winning picks for my bracket got me thinking about one of our favorite topics at Visible Equity: CECL methodology selection. Among the many changes and decisions financial institutions will need to make in order to comply with the new CECL Accounting Standard Update (ASU), perhaps the biggest is deciding which loss method to use to collectively review loans and other assets evaluated at amortized cost.
The ASU references static pool, vintage, probability of default, discounted cash flow, and roll rate as potential methods, but how do you know which method(s) is most appropriate for your institution?
To help you in your efforts to choose the right method(s) for your institution’s portfolio, let’s focus on three important factors to consider when making your decision: feasibility, performance, and management judgment.
Feasibility. The first factor is to review your data quality and completeness on a pool level to determine which methodologies are feasible based on this review. If certain required data is limited or unavailable it may preclude the use of some methods.
Performance. The next factor is to backtest each method. This is accomplished by estimating your allowance on a historical data set and then comparing the results to actual losses for a comparable period. Backtesting should be performed on various data dates and for a variety of methods and settings.
Management Judgment. The final factor is management’s experience and judgment. Management should carefully consider the pros and cons of each method, their assumptions and limitations for use, and the sustainability of preparers using a particular method.
To further illustrate how these factors apply, we have published a CECL Methodology Selection Guide. You can download it here or find it in our resources section under eBooks.
Applying these three factors in your decision-making process will help you cut through the CECL methodology madness and put you on a path towards a winning calculation of your allowance. But it probably won’t save your tournament bracket if it’s already busted. Good luck!