It’s been just over 18 months since the Financial Accounting Standards Board’s new rules around current expected credit losses took effect, and credit unions that transitioned to that loss model finally have some hindsight.
One of the biggest shifts has been how lending and finance leaders consider qualitative and environmental factors in anticipating loss reserves.
CECL adoption drove huge increases in allowance for credit losses (ACL), and it came at a time when earnings were drying up due to economic factors such as inflation and rising interest rates. Delinquencies and charge-offs are consequently on the rise, making the job of allowing for credit losses even more challenging.
“For ages and ages, and for ages yet to come, how you measure credit on the balance sheet is really important,” says Daniel Smith, CFO at Wright-Patt Credit Union ($8.6B, Beavercreek, OH). “It’s one of the most critical measures, but it’s also one of the most judgmental measures. No matter how much people try and box it into a model number — old method, new method — at the end of the day it still requires management oversight and analysis.”
The move to CECL accounting helped shine the light on lifetime losses in portfolios, which will help credit unions recognize credit losses in a more timely fashion through the use of an expected-loss model instead of an incurred-loss model. CFOs say CECL has created clear processes, more collaboration between finance and lending, and more focus on forecasting — but it has also added more work to an age-old process.
“It is a little bit more work, but when you think about an organization with a balance sheet where 90% of our assets are in loans, this is what we do,” says Rhonda Pavlicek, executive vice president of finance and risk and chief financial officer at University Federal Credit Union ($4.2B, Austin, TX). “We have to be on top of managing that risk and making sure we’re pricing and reserving those appropriately. Banks implemented CECL in 2018 and 2019. We’ve had a lot of opportunities to learn from the banking industry’s experience.”
Both Wright-Patt and University moved to CECL on Jan. 1, 2023, and the impact on was immediate: Loss reserves doubled at University and increased 41% at Wright-Patt. Additionally, Wright-Patt experienced nearly $1 billion in loan growth in the past 18 months, so its credit reserves-to-loans ratio grew from 0.81% to 1.45% reflecting both the adoption of CECL as well as portfolio changes.
“Part of that growth came from volume, but part of that also came from changes in credit risk – some good, some not so good,” Smith says. “Credit card losses, for instance, are higher now than they were at the time we made the transition, as are our auto losses. Commercial, on the other hand, is probably the same, or a little bit better, based upon the mix of credit that that we actually have.”
What’s Inside The ‘Black Box’?
The transition to CECL was a boon for financial consultants and specialized modeling software, but off-the-shelf products can only go so far. For example, the consultant University worked with provided multiple options for models and calculations.
“The team did a lot of work to really try to understand which methodology we should use for which portfolios,” Pavlicek says. “They sliced and diced it multiple ways. We didn’t do an across-the-board approach; we did different types of modeling and different types of approaches for different portfolios.”
By contrast, Wright-Patt initially used a vendor’s model and compared the results to in-house estimates. However, Smith says some results didn’t seem consistent with what it expected the credit risk in the portfolio to be, based on different alternate views. For example, the credit union used static pool losses for its auto loan portfolio, and the results were not consistent with the third-party model.
Wright-Patt ended up using a combination of both vendor-provided and in-house models, and often uses the alternate views as a challenger to provide a reasonable balance. The problem? The model was too opaque to justify.
“It’s the infamous ‘black box,’” Smith says. “At the end of the day, we’re responsible for all the numbers that go onto our balance sheet, black box or no black box. So, that proved to be difficult for us to address.”
Smith says the credit union reviews loss experience going back 10 years or more for various loan types, looking at changes for both the current month and on an annualized basis. He also uses Peer Suite from Callahan & Associates to pull in proxy data as well as charge-off rates at small community banks, Blue Chip Economic Indicators reports, and the Wall Street Journal Economic Forecasting Survey.
When you think about an organization with a balance sheet where 90% of our assets are in loans, this is what we do. We’ve got to be on top of managing that risk and making sure we’re pricing and reserving those appropriately as we need.
Local and national unemployment rates are also key indicators, Pavlicek says, and University considers inflation, consumer spending, and other factors in its calculations, including trends in home and car prices.
“As we know, when someone goes into delinquency and charge-off, the prices could impact those pieces,” she says. “So we use that for all macro views to determine where there’s some risk, and then we determine how we use that within the qualitative components.”
The mix of loans within the portfolio impacts the sensitivity to these economic changes. For example, nearly 42.6% of University’s portfolio consists of new and used auto loans, which carry shorter terms and are less susceptible to economic swings. In comparison, first mortgages and other residential loans account for 42.9% of the portfolio.
“The model is one input that we use, and we think about our loan portfolio and the attributes within that,” Pavlicek says. “As an organization, has our risk shifted? Has underwriting shifted? We anchor to what internally is going on from a micro level, and then we look at the macro environment. And that’s where the qualitative and the environmental factors come in.”
At Wright-Patt, auto lending makes up 38.5% of the portfolio, compared to mortgages and other residential loans (36.7%) and commercial loans (12%).
“You need to have a good, reliable model that takes into account not just your loss estimates, but all the other things that happen — like prepayments and so on — that can have an impact on how much you need to reserve,” Smith says. “That’s especially important for longer-tenure products.”
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An Ongoing Dialog With Lending
The transition to CECL has also spurred a closer working relationship between finance and lending. Both credit union CFOs meet at least quarterly with their respective chief lending and risk officers. University also formed a CECL council that meets quarterly. It is made up of the chief risk officer, chief lending officer, and vice presidents of operations, finance, retail, and lending.
“We have a cross-functional group across the organization looking at this to make sure if there’s anything we need to be thinking about or approaching from an analytical perspective,” Pavlicek says. “We’ve got the qualitative dialogue happening. That’s been our approach, and it’s served us well so far through the last 18 months.”
It’s also important to keep the board informed of any changes to the model, adds Smith.
“We have a quarterly reporting channel where we provide that information, but [if something happens] where we have a big change, we’ll escalate that not only to the CEO but also to the board so that they’re aware,” he says.
Looking Ahead
The shift to CECL has spurred University to not only actively review pricing but also work closely with the collections team to understand headwinds that could cause problems for borrowers.
“It’s working both within lending and the collections team to really to make sure we’re being prudent and lending appropriately but also not putting people in positions that really can’t afford,” Pavlicek says.
Although the data being reviewed is in the past, Smith says he hopes to apply CECL to more forward-looking decisions. Historically, the credit union has offered a product and then waited to see how it performed in the marketplace.
“I’d rather be at the point of saying, ‘Well, let’s see, we want to go and help serve this segment, so I wonder how that will impact for credit reserves?’” he says. “We need to advance that, and we’re not there yet. But it starts with examining what has happened when you make decisions and then looking at the subsequent results.”
The move to CECL has prompted credit unions to look at their loan portfolios in new ways. For example, although University isn’t segmenting its portfolio by age, it is looking at the potential impact of economic changes on credit cardholders ages 18 to 24, who experience higher delinquency rates.
Was moving to CECL worth the effort? Well, it’s a mixed bag, Smith says.
“I love the fact that we are looking at a lot more data and talking about credit in a much deeper fashion, but it does consume a lot of resources and a lot of time to go through that,” he says. “I guess that’s the blessing and the curse: You get a lot more great information that you have to look at. I think we’re still learning at this point. Actually, I dare say we’ll always be learning.”
