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Portfolio Risk & CECL Allowance Calculation CECL Accounting CECL Models

Do risks lurk in your CECL model? Risk assessments identify and address potential issues

Baker Eddraa, CPA
August 26, 2024
Read Time: 0 min

CECL model risk assessments

Possible areas of material misstatement in a CECL model can be identified with a risk assessments.

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Takeaway 1

The forward-looking CECL approach to estimating the allowance for credit losses introduces risks that auditors and examiners are scrutinizing.

Takeaway 2

Starting CECL model risk assessments at a high level ensures the focus is on data inputs, assumptions, documentation, and estimates. 

Takeaway 3

Consider risks tied to methodology, the use of third parties, management bias, and estimation uncertainty during a CECL model risk assessment.

Model evaluation

Auditors and examiners eye CECL risks

The Current Expected Credit Loss (CECL) model represents a significant shift in how financial institutions recognize credit losses. The forward-looking approach to estimating the allowance for credit losses introduces several risks that auditors and examiners are scrutinizing. Understanding how to identify these potential CECL risks is essential for ensuring compliance and accuracy in credit loss estimates.

Robust risk assessments are crucial for model oversight and governance. I recently discussed appropriate risk and control environments for CECL during an ABA webinar hosted by Mike Gullette, the ABA’s Senior Vice President of Tax and Accounting.

ABA member Abrigo has worked with hundreds of institutions on CECL, starting long before the updated model was issued in 2016. The CECL solutions provider and its advisors helped SEC filers (first adopters), and they continue to work with large and small institutions. These best practices for identifying risks in CECL models are based on information gathered via client interactions, auditors and regulators, and our work with other industry players during the CECL “learning curve.”

Proper control frameworks

Why a CECL risk assessment matters

Financial institutions are required to have controls in place to ensure compliance and the best estimate for credit losses. Unsurprisingly, building a proper control framework is easier if you first identify the risks.

A CECL risk assessment is foundational for pinpointing risks of material misstatement within the CECL estimate and determining management actions to mitigate these risks. At the end of the day, the idea is to be ready in case a recession occurs. Financial institutions want the best estimate and enough reserves in place to ensure safety and soundness.

At its core, a CECL risk assessment asks, "What could go wrong?" Starting at a high level helps avoid getting lost in the complexity of CECL and ensures the focus remains on data inputs, assumptions, documentation, and estimates. Once high-level risks are addressed, a more granular review can follow.

Stay up to date with CECL best practices.

In addition, remember to re-evaluate risk assessments continuously because the risks of material misstatement may change over time.

Methodology, bias, estimates

Key risks in CECL models

The following high-level risks should be considered in a CECL risk assessment:

Methodology

CECL’s principles-based approach allows for multiple methodologies to develop accurate, compliant estimates. Nevertheless, a primary risk involves the selection and appropriateness of the methodology used. It's also crucial to revisit methodologies, especially as the bank grows or ventures into new business areas.

Questions to assess methodology risk include:

  • Has the model changed since the adoption of CECL?
  • Do credit risks within the loan portfolio remain the same?
  • Is management (and others charged with governance) comfortable with the methodology?

Specialists/third parties

Using specialists or third parties can pose risks if not managed properly. One common area of examiner concern is that the bank has relied too heavily on the third party. Management must be comfortable in their understanding of specialists’ results and be able to explain them. Questions to consider related to third-party risk and CECL outsourcing include:

  • Is post-adoption monitoring “due diligence” needed?
  • Have we reassessed the use of the specialist/third party?
  • Are controls established by the specialist/third party sufficient to rely on information (SOC 1)?

Management bias

Bias can affect data inputs and assumptions, making documentation of these components critical. Significant assumptions must be well-documented and based on empirical data. Questions to consider include:

  • Are significant assumptions well documented?
  • Is the data being utilized relevant for the intended purpose?
  • Does the methodology anchor to a specific desired result for CECL? (e.g., “I want CECL as a percentage of loans to be around where my peers are.”) Examiners and auditors won’t like that.

Estimation uncertainty

Remember that examiners and auditors will ask about the source of your estimations and want to see documentation supporting the processes. Understanding factors that generate uncertainty in the allowance estimate is crucial for assessing CECL model risk. This is part of ensuring the model is working as intended. Questions to consider include:

  • Where are the sources of estimation uncertainty?
  • Has a loss driver analysis been completed?
  • What were the results of any backtesting/any retrospective review?

Transition to CECL controls

Post-assessment action plan

Once an institution completes a CECL risk assessment, the following steps are recommended to transition to control activities:

  • Compare identified risks to current control activities to ensure adequacy to determine whether the right controls are in place.
  • Identify control gaps or enhancements needed.
  • Assess desired precision versus available resources (staff, investments, etc.).
  • Develop and implement an action plan to update control activities.
  • Ensure all relevant stakeholders are part of the process. From a risk profile and control framework perspective, this should include loan operations, treasury, credit administration, and accounting and finance.

A CECL risk assessment is the first step in identifying and managing areas of models that could pose compliance issues with auditors and examiners. More importantly, assessing risk in the model is a CECL best practice that ensures allowance calculations are accurate and will support continued lending by financial institutions—a vital function for their communities.

For more information on CECL solutions, visit Abrigo’s CECL solutions.

See this checklist to prepare for your next bank or credit union exam: "Examiner focus: 4 areas to check"

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About the Author

Baker Eddraa, CPA

Vice President, Advisory Services
Abrigo Advisory Services Vice President Baker Eddraa specializes in providing financial institutions with consulting services related to CECL preparation, methodologies, and transition; purchased loan accounting; technical research; and strategic planning. Prior to joining Abrigo, Baker was an accounting manager at a $34 billion financial institution, serving as the merger/acquisitions, allowance,

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