Although the new accounting standard known as CECL is a requirement, bankers need to stop viewing it through that lens. CECL has many silver linings.
It provides bank management with a motive to holistically re-think and invest in data and analytics. Just about every industry is becoming increasingly data driven, and banking is at the top of the list. Like it or not, the ability to compete is going to be linked to a bank’s data and analytics capabilities as the decade progresses. The justification for a bank’s independence as a financial institution will hinge in part on this capacity.
Rest assured that those who approach CECL in a vacuum will be wasting an opportunity to rethink their bank’s strategic outlook at a time when it is needed most. Even beyond data, community bankers who are responsible for evaluating CECL providers should require that the solution be capable of directly integrating with other critical processes within the bank.
Large banks know that a cohesive symbiotic risk management and strategic and capital planning program unlocks critical insights that optimize performance. FinTechs have been flirting with such an approach, albeit in a variety of different ways. But they lack the competitive advantages of a bank charter. CECL offers community banks the perfect opportunity to start down this path because it requires loan-level information, which is the heart and soul for every critical bank process I will discuss in this article.
Over time, all these processes, including CECL, should be fully integrated with one another. They should have a circular relationship in which each process both requires and provides data to the other processes, giving management a complete picture of the bank. Below are several examples of how CECL can inform these processes in a synchronized manner so that a bank’s strategic plan is fully connected to on-the-ground activities at the loan level.
Loan Underwriting
If done correctly, CECL should be driven by loan-level risk characteristics such as risk rating, loan-to-value ratios, debt service coverage ratios, credit scores, NAICS code, collateral type, origination date, maturity date, and more. A bank’s CECL estimate for a given loan should fluctuate based upon these characteristics.
This enables underwriters to play with various structures of the loan BEFORE it’s originated and have a full understanding of the impact on the CECL reserve, which is essentially the credit expense for that loan. Need to reduce the credit expense for the prospective loan? Perhaps the underwriter should require more collateral from the borrower, or the loan balance should be reduced to lower the LTV ratio. Underwriters deserve to know in real time what impact these scenarios would have on the CECL reserve.
Other models that attempt to do this but are not connected to the CECL model are a waste of time. These other models might tell you that your risk is 0.20% of the loan balance, but what does that matter if your CFO is going to have to add 100 basis points of q-factors when this loan is bundled with the rest of the portfolio at the time of financial reporting?
Loan Pricing
Let’s take underwriting a step further to loan pricing. For a loan to be priced effectively, you need two critical numbers: (1) the credit expense for the loan, and (2) the capital required to support the loan. Without estimates for these two numbers, you are going blind with respect to ensuring that the loan has sufficient profitability and return on capital.
There are many excellent loan pricing models available in the industry, but their shortfall is that these two numbers are estimated in an environment that is completely disconnected from how the bank derives its actual CECL expense and capital adequacy.
As mentioned in the previous section about loan underwriting, the credit expense for each loan should be calculated by the same model driving the bank’s CECL calculation or you will get whacky disconnects. The same thing goes with capital adequacy.
Stress Testing
I have written earlier articles about how the CECL model really is a stress testing system and how a stress test is really the only viable calculator for capital adequacy in a post-2008 world, lessons that are essential for community banks when they decide whether to adopt the Community Bank Leverage Ratio framework. Bottom line – you must calculate the capital requirement for your bank as a whole or any of its parts, including individual loans, with a stress test. Most existing models in the marketplace fail to do this.
A loan that appears to be capital efficient may not be nearly as efficient as your model tells you. Consider a hotel loan that was made with a 70% LTV in 2019 prior to the pandemic and when hotel valuations were at their peak. It will have a much higher capital allocation than another hotel loan that was made with a 75% LTV in 2021 after hotel valuations cratered. Only a well-designed stress testing system will properly capture the importance of vintage in this example.
Strategic Planning
Under CECL, the days of targeting a certain amount of basis points (say 125 bps) of a bank’s loan portfolio to establish its reserve are over. Strategic planning and annual budgeting will need to capture current and forecasted economic conditions and underwriting strategies to properly estimate the projected loan loss provisions in the P&L. Strategic planning should focus on making types of loans that maximize the trade-off between risk and return. The risk piece must be driven by the CECL and stress testing models.
Banking in 2021 is a tough business. Zero interest rate policy has crushed net interest margins. Even with an expected yet temporary economic surge potentially on the horizon, loan growth is expected to remain muted, especially for CRE, which is undergoing structural changes in a post-pandemic world.
Fierce competition will exacerbate a pre-pandemic trend in which banks were competing on both underwriting and pricing to win lending business. This could infest your balance sheet with loans that are not sufficiently profitable and capital efficient. Integrating CECL and by marriage, stress testing, with strategic planning allows bankers to quantify their loans while also discovering pockets of loans with hidden value.
M&A
CECL certainly changes the dynamics of purchase accounting for M&A, but that is not what I am going to discuss. Frankly, I think that is more of a distraction from the real strategic issues that involve the impact of CECL on M&A. The real issue is that M&A is first and foremost a growth strategy. As a result, it should be evaluated relative to other growth strategies, most notably, organic growth. When organic growth is weak, M&A is a better strategy by default.
Organic growth prospects are weak now. M&A allows banks to grow their loan book faster than organic growth, but how much more valuable is that acquired earnings stream than organic growth? If you know the answer to that question, you are well on your way to calculating how much a given target bank is worth to you.
Unfortunately, the M&A models operated by most investment banks are antiquated and rely far too heavily on historical performance to forecast future results. Instead, banks need to evaluate the profitability and capital efficiency of the portfolio they are potentially acquiring. If you go back and re-read the previous section about strategic planning, you will see how the only viable way to do this is with an integrated CECL and stress testing system.
In other words, the same tools used to evaluate organic growth strategies should be the same tools used to evaluate M&A. Loans are the primary source of revenue for banks. Credit risk is a critical expense that must be considered to evaluate the efficiency of this revenue source. Like it or not, the only measurement of credit risk that matters is CECL because that is what ultimately gets reported to shareholders.
Wrap Up
Look, I get it. Budgets are tight. Banks typically tend to invest in technologies, including data and analytics, only when they truly have a need or when they can see a clear and concise ROI. The contents of this article are not necessarily new because of CECL. But CECL is a requirement, and therefore, it creates a need for the bank, which in turn, creates a budget for investing in CECL. Smart banks should see the big picture here. Don’t squander the opportunity to kill multiple birds with one stone. If you invest in the right CECL solution, it will put you on the path to evolve your use of data and analytics and synchronize critical processes within your institution. If you don’t, you may win the CECL battle, but you’ll risk losing the war.
