What Community Banks Need to do to Prepare for CECL

January/February 2017

What Community Banks Need to do to Prepare for CECL

By Adam Mustafa, Invictus Co-founder

Invictus Return on Required Capital Ratio

While smaller banks are in a better position to benefit from CECL from a technical perspective, they will struggle the most with the implementation due to a general lack of sophistication and the relative cost of using third-party tools. Smaller banks may also find themselves caught in the middle of two conflicting forces. In one corner, the service providers that stand to benefit the most from CECL are using scare tactics to convince banks to spend oodles of money today on a so-called solution. “Best start yesterday or else you are doomed,” they say. In the opposite corner, overly passive and reactive auditors are advising banks to wait until more guidance is available. The right answer for community banks is somewhere in the middle.

For now, community banks should be proactive, but they shouldn’t spend too much money. My advice:

  • Determine what additional data you need down the line, and devise a plan to adjust your business processes to collect it
  • Rethink your loan classification systems and their portfolio
  • Figure out what is best for your As federal regulators noted in a Financial Institution Letter in December, “CECL allows institutions to apply judgment in developing estimation methods that are appropriate and practical for their circumstances.”
  • Understand the role of vintage in CECL. Don’t confuse it with seasoning. The risk profit of a loan is primarily a function of the economic conditions that existed on the day the loan was originated. What’s most important is the ability to measure the economic conditions that exist in the expected environment underpinning your CECL model against the economic conditions that existed for each vintage. In 2011, economic conditions were worse than in 2007. Therefore, the 2007 loans should require more of a reserve than loans originated in 2011, but not as much than a loan written in 2016.
  • Thought leadership on how you adapt CECL to your institution will be rewarded. Be aggressive on data gathering, but don’t buy a black-box solution. Your CECL system can be simple; don’t believe the hype about how it has to be complex.

The best way to prepare for CECL is to start small, and build out.

Believe it or not, most banks have the ability to run a very simple CECL analysis right now. The secret to CECL will be loan portfolio segmentation. If you get your segmentation right, you will find that it’s 80 percent of the battle. Mock calculations can then be performed on each segment. The assumptions driving the model might not be 100 percent accurate, but at least this would give your bank a starting point to determine what additional data you need to improve such assumptions. Then, as you get more data, you run more mock calculations until you get it right. That would enable your bank to evolve its calculations by the time CECL is implemented. The worst thing you can do is try to build a perfect system on Day One. That is what will lead to wasted money and time.

Invictus Data Insights

Invictus performs a quarterly analysis on all FDIC- insured banks in the country to assess their best approach to M&A. The analysis is based on the post-stress capital ratios of banks, plus the Invictus Ratio, which generates a gauge of five categories: Balanced, Should Buy, Must Buy, Should Sell, Must Sell and Outlier. (This is not a prediction of what banks will do, but rather an indication of what they should do to maximize shareholder value.) The latest “Leaders and Bleeders” analysis, based on 2016 Fourth Quarter data, shows a slight increase in the number of Seller banks and a slight decline in Balanced banks, most probably because of the low interest rate environment. Loan income declines each quarter as older, higher interest rates roll off and are replaced with lower rate loans.

Broadly, the Seller banks have poor post-stress capital ratios, lose capital fast under a stress test, and do not achieve good returns on their required capital (where required capital is based on a stress test).

Buyer banks are in better shape from a capital point of view, but should consider acquisitions of more efficient banks (those with a higher Invictus Ratio) to improve the bank’s performance. Balanced banks have good post-stress capital and good efficiency  To see where your bank stands on the Invictus Gauge, please contact MandA@jamg23.sg-host.com Statewide graphs of the Leaders and Bleeders analysis can be found on the Invictus website.

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