The initial year of implementing Current Expected Credit Losses (CECL) regulations across U.S. financial institutions marked a transformative period for credit unions. Moving beyond the incurred loss model, CECL introduced a forward-looking approach that requires institutions to estimate and recognize potential credit losses over a loan’s lifetime. This change demanded new methodologies, enhanced data practices, and updated risk management techniques, especially for credit unions that had not previously relied on such comprehensive projections. Here are key lessons from the first year, adjustments made by credit unions, and strategies for effectively navigating the second year of CECL.
Year One Takeaways
Challenges in Economic Forecasting—A foundational aspect of CECL is its reliance on economic forecasting to predict lifetime expected losses. However, 2023’s economic turbulence, characterized by fluctuating inflation, high interest rates, and variable unemployment, revealed the challenges of integrating accurate economic projections into CECL models. Many credit unions found that changes in these factors impacted their allowances, and they often needed to rely on qualitative adjustments (judgment-based adjustments) to offset forecast uncertainties. The heavy reliance on these adjustments highlighted the importance of versatile scenario modeling, particularly when economic stability is uncertain.
Adjustments to Risk Models and Practices—In response to CECL’s requirements, many credit unions adopted simplified CECL models provided by regulatory bodies or third-party tools that factored in shorter-term, reasonable forecasts. While smaller credit unions successfully implemented these simplified models, larger institutions faced the challenge of refining model assumptions and tailoring strategies to address the diverse segments within their portfolios. Machine learning techniques were adopted by some institutions to streamline model adjustments based on changing forecasts. This flexibility in modeling underscored the need for adaptable systems that can recalibrate quickly without significant cost.
Implications for Capital Reserves and Operations—CECL’s approach required credit unions to hold reserves that reflect potential lifetime losses, creating significant capital pressures for institutions with high consumer and small business loan exposure. The forward-looking nature of CECL meant that, unlike the incurred loss model, reserves had to be allocated at origination to cover projected losses. As a result, some institutions experienced increased capital requirements, especially during economic downturns. Going forward, it’s critical for credit unions to leverage historical data to effectively support reserve requirements and manage capital impacts.
Managing Cyclicality within CECL—Although CECL was designed to be countercyclical—helping credit unions to build reserves in stable economic times and thus easing reserve requirements during downturns—cyclicality still became apparent in its application. Economic declines increased allowances as credit unions adjusted to changing risk factors. To address this cyclicality, some credit unions have modified their forecasting intervals and adjusted their allowance models. Looking ahead, closely monitoring CECL allowances and planning for worst-case scenarios may help institutions better manage these cyclic effects.
Year Two Expectations and Strategies
Improving Data Quality and Model Flexibility—To prepare for Year Two, credit unions must focus on data quality and granularity within their CECL models. Elements such as historical loss patterns, borrower profiles, and economic indicators should be expanded to generate more precise estimates of losses. During periods of economic volatility, reliance on model adjustments is expected to increase, making it essential for credit unions to enhance data practices and improve model validation processes. Integrating diverse data sources can also reduce model risk, strengthening CECL frameworks.
Scenario Planning and Dynamic Forecasting—With continued economic uncertainty expected in 2024, dynamic scenario planning will be crucial for credit unions to stress-test portfolios under a variety of economic conditions. Regulatory tools and resources, such as those provided by the NCUA, offer valuable guidelines for incorporating stress tests and adjustments. By using adaptive models, credit unions can minimize the need for judgmental adjustments and improve the reliability of forecasts over time.
Streamlining CECL Models for Long-Term Application—CECL necessitates ongoing recalibration, particularly for institutions that initially adopted basic models. Over time, it will be beneficial for credit unions to enhance their current models to better align with specific portfolio characteristics. Several credit unions have incorporated parallel tracking of both CECL and incurred loss models, allowing them to smooth transitions and refine projections gradually. This approach can increase data resilience and better prepare credit unions for evolving regulatory expectations.
Investing in Training and Internal Knowledge—Credit unions that invested in internal expertise and staff training for CECL benefitted from smoother adjustments, especially when economic conditions called for model modifications. Staff training on CECL’s specific data and modeling requirements will remain essential as institutions adapt to potential regulatory reviews that examine CECL practices more closely. Additionally, maintaining clear documentation of model assumptions and estimation processes will help credit unions manage the evolving complexities of their models.
Looking Ahead: Adapting to Regulatory and Economic Shifts
As CECL implementation continues, regulatory standards are likely to become more defined, and credit unions should anticipate updates on best practices. Given the importance of data in CECL compliance, institutions must be ready to respond to any shifts toward data-driven regulatory expectations. Economic volatility will also require credit unions to maintain close vigilance on broader macroeconomic trends and update models to incorporate emerging risks. Year One of CECL demonstrated the importance of adaptable models, proactive capital planning, and robust data practices. As credit unions enter Year Two, the focus will be on refining CECL processes to support long-term financial stability and ensure compliance, even in unpredictable economic climates. Credit unions should consult with regulatory liaisons or financial advisors to ensure their CECL models meet evolving standards and optimize long-term resilience.
Nicole Davis is a Manager at ARB. She provides comprehensive auditing, compliance, and consulting services to financial institutions, dealerships, and non-profit organizations. She helps clients to navigate complex regulatory landscapes and ensure fiscal responsibility and operational efficiency.
