9/1/17 - Aligning Stress Tests with CECL Adoption
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9/1/17 - Aligning Stress Tests with CECL Adoption

The recent rise in the number of bank mergers and acquisitions has pushed more banks past the key regulatory threshold of $10 billion in assets. The trend represents a positive sign for the economy and the banking industry. But many of these banks with newly acquired assets are now subject to regulatory requirements they did not face before. With assets of $10 billion or more, banks have to carry out Dodd-Frank Act stress testing, as well as meet the compliance demands in the Federal Reserve Board’s SR 14-3, SR 12-7, and SR 16-11 guidance. In addition, over the next two to three years, banks of all sizes are required to adopt the new accounting approach of allowing for current expected credit losses. Banking organizations will surely benefit from aligning their stress tests with concurrent efforts to prepare for the CECL standard.

Stress testing commonly requires banks to estimate stressed credit losses over a nine-quarter horizon — and over an additional four quarters for estimating a stressed allowance for loan and lease loss. Most midsize banks follow a portfolio-level modeling and estimation approach. The modeling is often supported by discussions of portfolio segmentation, the identification of key risk drivers, and the selection of usable peer data where required. These efforts help firms develop comprehensive models for estimating balances, defaults, and loss severity for each segment.

The process closely resembles the one used by banks to set their loan-loss allowance — identifying the cohorts (segments), determining the allowance levels and environmental factors for each, and then setting the overall allowance for a defined forward period.

Given the similarities between stress testing and modeling for loan losses, banks can boost efficiency by aligning the two — and make both exercises more effective at the same time.

Areas of Synergy Between Stress Testing and CECL Methodology

AREA STRESS TESTING CECL

Data Availability

Assesses the availability and accuracy of key data on credit risk (e.g., charge-offs and recoveries) to identify gaps or issues (e.g., historical data limitations arising from minimal losses, acquisitions, and lack of charge-offs)

Determines the feasibility of retroactive data collection

Identifies available data on peers and near peers to supplement the bank’s internal data sets

Follows same procedures, but takes in additional key data sets — such as historical ALLL

Portfolio Segmentation

Identifies the material portfolios

Assesses portfolios for areas of homogeneity and heterogeneity

Divides the entire loan portfolio into (typically five or six) relatively homogeneous segments for the purpose of modeling

Follows same procedures

Constructs granular loan portfolios based on similar risk characteristics, including loan term, geographical location, industry of the borrower, historical and expected credit-loss patterns, collateral type, effective interest rate, and reasonable and supportable forecast periods

Typically divides portfolio into more segments — perhaps nine to 12

Risk Drivers

Undertakes regression analysis on data to determine the potential risk drivers used in the modeling effort, possibly including regional economic variables

Follows same procedures

Given the differences between the two exercises, however, there is good reason to keep the modeling approaches distinct.

Areas of Difference Between Stress Testing and CECL Methodology

AREA STRESS TESTING CECL

Forecast Period

Follows user-defined period, but nine quarters for DFAST, with four additional quarters for ALLL

Spans life of the loan and depends on duration of individual transactions and portfolios as a whole — but longer than nine quarters

Modeling Methodology

Is typically driven by regression models for balance, probability of default, and loss severity — at the level of portfolio segments, but sometimes also at the loan level, data permitting

Is typically consistent across portfolio segments (but does not need to be)

Follows loss rate, vintage year, aging schedule, discounted cash flow, and roll rate, as well as loan-level metrics

Can differ for different portfolio segments

Results

Generates estimates of balances, defaults, and losses over the forecast period

Generates estimates of defaults and losses over the life of the loans

Economic Environment

Uses regulatory scenarios for forecasting, typically regressing to the stressful history of the most recent financial crisis

Uses reasonable outlook for the economy — in line with the baseline and consensus views

Despite the differences in modeling approaches used for stress tests and CECL compliance, most banks nonetheless draw on the same area of expertise to excel at both. Firms can link the two exercises in such a way that they benefit each other, following many of the same broad procedures when determining the banks’ quarterly allowances and performing annual and ongoing stress tests.

Other Regulatory Challenges Above $10B

Banks passing the $10 billion threshold face several regulatory requirements and expectations in addition to the stress-testing and CECL requirements.

Important expectations include:

Data
  • Data collection and governance processes are assessed and constantly improved
  • Data frameworks are robust and include mechanisms for validation and data transfer
  • Data is handled in an automated and well-controlled manner
 
Risk Controls
  • Robust model risk management is in place and in line with the Federal Reserve’s SR 11-7  
  • Internal control functions are rigorous enough to ensure the integrity of stress-testing and ALLL forecasts
  • Firms adopt SR 16-11 risk management standards, including policies and procedures for major risk categories
 
Other Key Areas
  • Firms begin submitting call reports expanded to include probability-of-default and loss-given-default disclosures.
  • Board risk committees are held to stricter requirements.
  • Banks become subject to the Dodd-Frank Act’s limits on interchange fees.
  • The Federal Reserve’s supplemental guidance on internal audit begins to apply
  • Firms face higher expectations for managing third-party, cybersecurity, and other operational risks
  • Anti-money-laundering and sanctions-related compliance demands increase
  • Banks receive closer supervision by the Consumer Financial Protection Bureau
 

Even banks that remain under the $10 billion threshold will benefit from adopting the more sophisticated approaches that larger banks use to meet their stricter regulatory demands. These financial institutions have much to gain from establishing more advanced frameworks for stress testing, CECL compliance, data aggregation and governance, and general risk management. Doing so gives these banks the opportunity to incorporate elements and metrics that surpass their regulatory requirements and inform risk-based decision-making.

Developing Stress-Test and CECL Programs

Banks can develop stress-testing and CECL programs by first defining their goals for capital planning, DFAST, and ALLL — goals that may go well beyond meeting regulatory requirements (e.g., for enhanced analysis of the overall portfolio’s credit risk). By assessing current capabilities against regulatory requirements and industry best practices, many institutions will find they can draw on and enhance their existing capabilities to meet new requirements. Perfection is not the goal, but regulators nonetheless expect banks to be well-prepared and start early on their long-term implementation plans.

Firms that follow phased plans can allot time for transition, testing, regulatory feedback, and enhancements, before final implementation of their fully realized DFAST and CECL programs. Banks expecting to pass the threshold will find it beneficial to begin planning now, as early movers are likeliest to succeed in managing their regulators’ expectations, establishing solid frameworks, and finding ways to use current capabilities to develop new or enhanced programs.

How Promontory Can Help

Promontory Financial Group, an IBM Company, has unparalleled insight into regulatory requirements for banks preparing to cross the $10 billion threshold or meet the specific mandates of the CECL standard. Our experts have hands-on experience with institutions of all sizes and complexities.

We help clients develop and implement plans that fit the size and complexity of their unique organizations and meet or surpass regulatory expectations.

Our solutions, which scale with the complexity of the institution, include:

  • Developing phased road maps and implementation plans
  • Performing assessments of existing governance, infrastructure, and analytic capabilities against regulatory requirements and best practices
  • Advising on organizational structure and developing governance and control frameworks
  • Establishing reliable processes for identifying risks, as well as comprehensive risk appetite statements
  • Performing risk-materiality assessments to help develop suites of models at the right level of granularity for DFAST, CECL, ALLL, etc.
  • Developing regulatory submissions, internal reports, and supporting documentation
  • Designing programs for data collection and governance
  • Implementing programs for model risk management and internal audit

Contact Promontory

For more information about how we can help your financial institution prepare for DFAST and CECL requirements, please contact:

David Samuels
Managing Director and Global Head of Stress Testing Practice
dsamuels@promontory.com
+1 212 542 6776

Joseph Sergienko
Director
jsergienko@promontory.com
+1 202 370 0408