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Echo Partners Community Bank Blog

    CECL: Can we trust our regulators?

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    Our regulators and FASB have gone out of their way to repeatedly point out that CECL is designed to grow with the bank or credit union.

    Smaller and less complex financial institutions can use simpler models. If we don’t use complex loan level analysis now we won’t need to use it with CECL either.

    So why does a sense of disbelief still exist in the industry?

    It’s because we’ve seen this movie before and it doesn’t end well for community financial institutions.

    It started with the 2010 Joint Advisory on Interest Rate Risk Management.

    Smaller less complex institutions were assured that gap, for instance, remained a viable analytic tool for them. They were told they could run fewer, less intricate rate shock scenarios.

    While it sounded good coming out of Washington, it didn’t survive in the field.

    Soon examiners were offering “helpful suggestions” that involved imposing additional requirements and more sophisticated stress testing on smaller banks.

    So how can community financial institutions watch their back with CECL?

    I think a good common sense approach is to run an aggregate CECL model now but supplement it with a passive data warehouse just in case history repeats itself.

    CECL Adjustments

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    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:

    1. Frequency: Remember, with CECL you’ll have a chance to apply and fine tune adjustments at least quarterly.
    2. 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.

    Consider Simple CECL

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    Since historical loss rate makes up a big part of the CECL estimate, you should carefully select your CECL methodology.

    The biggest choice is aggregate vs loan level.

    CECL is designed to be scalable so smaller less complex financial institutions can use simpler methods. But even larger banks should stop and consider aggregate methods.

    Both FASB and our regulators have said it multiple times…If you are using a simple method now with ALLL you can use a simple method with CECL.

    Aggregate methods have 3 advantages.

    1. Data: All the data you need is already collected, organized and available.
    2. Segmentation: You are already using standard loan segmentation for your regulatory reporting.
    3. Peer Info: Peer data is easily obtained. Any areas on your loss curve where you might need to fill in the gaps is covered with peer data.

    The biggest reason to use an aggregate method is that you don’t have to reinvent the wheel.

    We all know that off-the-rack is less expensive than custom.

    Our clients tell us their biggest CECL concerns are they don’t have extra time, extra resources or the in-house expertise needed to solve CECL on their own.

    Aggregate CECL solves these problems.

    The Basics of CECL

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    CECL only has 3 main parts…

    1) Historic loss rates, plus adjustments for

    2) current conditions and

    3) expected future conditions.

    The biggest part of CECL, historic loss rates, is very similar to the loss rate calculations that bankers have been performing for the past 40 years. What’s different is the timeframe.

    Bankers are used to looking at annual loss rates but CECL requires us to examine lifetime loss rates. Same concept, different perspective.

    Here’s the point many bankers miss…

    Total CECL loss is the same as total incurred loss. It just happens sooner. It’s a timing difference.

    The adjustments are where we get to apply management’s judgment and good old fashioned common sense. You can fill in loss curve gaps using peer data, or shade your results with Q-factors.

    As with most regulatory items, a consistent process with thorough documentation trumps fancy analytics and statistical techniques.

    Conventional wisdom says you need a complex and expensive process. That’s just wrong.

    If you use a simpler process with today’s incurred loss method you can still use a simpler process with CECL.

    Do you have CECL questions?

    What's the Problem with CECL?

    What’s the problem with #CECL ?

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    Most bankers understand that CECL is on the horizon but they’re not focused on what to do about it.

    Maybe they think if they ignore it, it might go away...

    Put their head in the sand like an ostrich

    ...Especially if they’re from a credit union.

    But you better stop right there and accept it as if it were an unchangeable law of the universe.

    Here’s the reality…

    CECL is happening.

    FASB is not beholden to Congress.

    Ignoring CECL will not help.

    It’s time to get serious about understanding CECL, planning for it, and starting to run parallel.

    How is your board going to develop approved policies procedures and limits if you’re not even running your numbers?

    How will you prepare for CECL reserve levels if you don’t even know what they are?

    Where are you on CECL?

    3 parts of deposit profitability

    3 parts of deposit profitability.

    Deposit profitability requires you to adopt 3 main components.

    • The concept. Deposit profitability presents a different concept than what we have traditionally learned as bankers. Deposits aren’t just fungible funding sources but have different levels of profitability that we can manage and optimize. We can’t just measure the quantity of deposits. We must measure the quality of deposits.
    • A measuring tool. Starting to measure deposit profitability requires an instrument-specific measurement of every transaction from our core system. We can no longer rely on simple aggregate measures if we wish to calculate detailed and accurate P&L statements for each and every account.
    • Strategies. Applying strategies to grow deposit profits is the bridge that connects the concept and tool with our bottom line. Effective strategies require setting a profit target and changing account terms or behaviors to result in more profitable deposits. Typically this will require customers to hold larger minimum balances, pay more fees or reduce the volume of included but expensive transactions.

    Bankers grasp the basic concept quickly. The measurement process once fully vetted is widely accepted. Most uncertainty arises over requiring more profitability.

    Don’t listen to the naysayers

    Don’t listen to the naysayers.

    You know who I mean…

    …Those purportedly well-meaning colleagues and coworkers who have myriad reasons why your profit building initiatives will never work out.

    This is especially true with respect to strategies to grow your deposit profits. They’ll give you endless feedback why it won’t work and it almost always boils down to fear of losing customers.

    Let me ask you a question. Isn’t there a bank in your market that pays the highest deposit rate? But they don’t get all the business do they?

    Similarly there’s a bank that pays the lowest rate in your market yet they still manage to gather deposits. Don’t you think that’s evidence that customers bank for reasons that don’t begin and end strictly with dollars and cents?

    Especially when you consider what a hassle it is to change banks. That’s a good thing as it makes your deposits “stickier”. Surveys show less than 11% of depositors would change banks for any reason.

    Or think of your Q3 (low balance but hit profit targets) customers. They’re proof right inside your bank that this approach works.

    So why don’t you take a chance and run a smart test case on Q1 (small balance, subpar profit) deposit profitability. Experience shows that done properly you won’t lose customers but you will grow profits.

    Apples to apples deposit comparisons

    Apples to apples deposit comparisons.

    It’s inevitable once you start measuring deposit profitability. You need a framework for comparing similar accounts with different profitability.

    Why? Because those comparisons give strong evidence on the best paths to improve profits. Think about it. Would you rather try and build profits based on your own best guess or would you rather have solid evidence of what actually works?

    Start with grouping accounts based on balances (horizontal axis) and profits (vertical). 4 simple quadrants are all you need. Now compare accounts vertically so that you compare profits based on similar account balances. Here’s an example.

    Consider Q3 (small balance accounts that meet your profit targets) in the upper left quadrant. Compare Q1 (small balances but fail to meet profit targets) accounts in the lower left quadrant with Q3 to gain insights into how best to improve Q1 profitability.

    Comparing like-sized balances helps you zero in on the critical behaviors that result in different profit profiles. In this case (Q1 vs Q3) Q1 accounts are apt to have lower revenue components (fewer fees and less interchange) and similar delivery channel costs. But by limiting your comparisons to similar balances you quickly learn what’s realistic for these profit laggards.

    Two sides to the 80/20 story

    Two sides to the 80/20 story.

    There are really 2 sides to 80/20 deposit profitability.

    We usually focus on the 20% who drive 80% (or more) of your profits. That’s a great common sense strategy and I’d encourage you to continue building personal relationships with your best customers.

    But what about the 80% of depositors that represent 20% (or less) of your profits? How do we best handle them?

    There are 2 important subgroups of deposit customers in this less profitable 80% group. One easy answer concerns the group that is the least profitable. In fact they’re the 20% that drives 80% of your deposit losses.

    You must identify these depositors and determine why they are causing such significant losses. Typically these sorts of losses are produced by excessive transactions via expensive delivery channels. It’s not uncommon to see 2% of your average collected balances driving as much as 50% of your entire deposit delivery channel expense. You must find and fix these super users.

    The other group is less obvious. They’re the less profitable depositors that can be motivated to become much more profitable. In fact your goal here is to convert them into more of the 20% driving your biggest profits. They’re the future of your bank and your deposit profitability segments can help identify them.

    Sir Isaac Newton and deposit profitability

    Sir Isaac Newton and deposit profitability.

    Newton’s 1st law of motion says that a body at rest will remain at rest and a body in motion will remain in motion. These properties are often referred to as inertia. While we usually think about it in terms of physical bodies, Newton also does a pretty good job of describing bank deposits.

    Consider bank deposits in motion. This is hot money in search of the highest yield.

    These deposits tempt us to offer them a higher rate to capture them. After all, the thought goes, once exposed to our service and customer experience we’ll break them of their rate-seeking habits and have them forever.

    Don’t deceive yourself. They’re hot now and they will stay hot. They’re ever in search of the elusive best rate and you won’t change them.

    Now consider bank deposits at rest. They’re our basic long term customers.

    Think about things from their point of view. It’s a huge hassle to change banks. Plus they actually are comfortable with us and our bank. The only problem is that 50%+ of them are unprofitable.

    You can fix this with minor finetuning of account terms and fee structure. They’re not going to move.

    The risk-reward tradeoff for correcting this profit imbalance is tilted heavily in your bank’s favor. Think about this scientifically. Just ask Newton.

    Do you want to grow your bank profits with little to no risk? Click Here to  Discover How

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