Determining your historical loss rates is only half the CECL battle. Next you’ll need to determine and apply adjustments for both current and expected future conditions.
There are a lot of different points of view on adjustments.
My view is that bank-specific loss rates should form the overwhelming bulk of the CECL calculation. Then, adjustments should be used to shade the loss rates slightly one way or another.
Put another way if CECL was a steak, loss rates would be the meat while adjustments would be the seasoning.
If adjustments lead you to conclude that a more favorable credit environment exists, then slightly lower your CECL reserve rates. On the other hand if adjustments suggest a less friendly credit situation then slightly increase your CECL reserve rates.
There’s typically no need for adjustments to suggest a major shift away from calculated bank-specific loss rates.
Here are 2 reasons why:
- Frequency: Remember, with CECL you’ll have a chance to apply and fine tune adjustments at least quarterly.
- Impact: Small loss rate adjustments translate into bigger profit and even larger capital impacts.
If a long term credit trend develops repeated adjustments will compound.
What’s more important is that adjustments are symmetrical and consistent in both direction and magnitude.