Steps, Data and Methodology

Steps, Data and Methodology

By Prashant Dinodia, Director, Risk Advisory, FIS.

Prashant, can you please tell the Risk Insights readers a little bit about yourself, your experiences and what your current professional focus is?

I lead the risk advisory practice at FIS, supported by team of resources (like Bond and Ryan) who come from a strong background of econometrics and quantitative risk management. We have been helping our clients with their risk consulting needs for over a decade. The areas of our work typically range from risk modeling, credit scorecards, capital management, to loan allowance. We have been very successful to bridge the industry gap for risk modeling and consulting by providing tailored and multi-year engagements with our clients.

Our focus has evolved with the needs of the industry and regulatory environment but always centered around financial risk management. In the earlier days, most of our work revolved around capital management, risk appetite and allowance. In more recent times, the focus has been modeling around DFAST/CCAR stress testing and credit scorecards (PD/LGD). And once again we find ourselves in a situation where we find that the needs of industry are pivoting towards the new allowance framework (CECL). CECL to us is almost an extension of the modeling we have performing on the scorecard and stress-testing side, although it does have its own nuances. So we are very excited to help clients as they navigate through the new world of CECL.

At the CECL Congress 2018, you will be leading a Masterclass on, ‘CECL – Steps, data, and methodology’. Why is this a key talking point in the industry right now?

There are two key dimensions why CECL is generating such discussions and interest: First, the pervasiveness and impact of the guidelines. We are talking about a regulation which almost all banks and financial institutions will need to comply and there is direct impact to their bottom lines. Second, banks are uncertain about the best approach or practice for their institution.

Since CECL is a principle-based guideline, rather than a prescriptive set of rules, the flexibility and latitude of valid approaches lead to a lack of certainty and grounds of ambiguity in the industry. Events like the CFP congress and the CECL masterclass are very timely when practitioners share their insights and ideas, offering a range of ‘best practices’, which can allow institutions to plan for CECL with a sense of comfort and confidence.

What are the key considerations that need to be made when developing a CECL action plan?

For most of the industry, CECL will become a reality at the start of 2020. This means the current and following year will be crucial. Based on the global experience of IFRS 9 (CECL’s global equivalent guidelines) we would recommend institutions to keep enough time for a parallel run of at least 2 quarters (6 months), planning a development and implementation timeline backwards from there. Having a CECL action plan that includes a calendar of tasks, and defines outcomes is indispensable, and should not be delayed.

We talk to banks about two initial areas of focus when developing an action plan. First, we think institutions should perform a readiness/gap analysis to assess what CECL approach works best for their portfolio. As part of the gap analysis, practitioners should review internal data and risk models, focusing on opportunities to leverage what is in place, as much of CECL can be done using existing tools.

The other important consideration in developing an action plan is the involvement of all stakeholders in the process. Given the wide impact of CECL, it is important that all relevant sections of the organization (including external stakeholders like the auditors and examiners) are involved and consulted. Hence, having a well-defined CECL steering committee structure is needed earlier than most institutions often think.

What are the key risk management tools and frameworks needed to build CECL? And have you got any advice for your peers?

One advantage (and possibly challenge) of CECL is the flexibility offered by regulators. There is no one size fits all. As such banks will have to evaluate what approach works for them on a case-by-case basis. The key risk management tools really depend on what CECL approach a bank selects for its portfolio. CECL building blocks can range from loan-level PDs / LGDs to portfolio-level loss rates.

In terms of advice, we would recommend that banks choose a CECL approach in line with how they currently manage risk for other applications. If a bank has complex risk models for loan origination and stress testing, then they should consider modeling CECL with a similar degree of sophistication. Conversely, banks with smaller risk management practices do not necessarily need complicated risk models solely for CECL compliance. How a bank approaches CECL should be consistent with its risk management practice.

 

Finally, what challenges do you foresee with CECL implementation over the coming years?

CECL is not an easy regime. Given, again, the IFRS 9 experience globally, we don’t think all institutions will have a smooth ride. There are several areas, where we expect CECL to throw challenges. First and foremost, given the number of internal and external stakeholders involved, it will be a challenge that all parties are converge on practices and numbers.

Especially early on, when there are few benchmarks and everyone is trying to figure out as what is acceptable. Beginning with a simple and defendable approach may be optimal. As best practices emerge, sophistication can be layered into the bank’s CECL methodology. So we certainly see the first few years of CECL where things will need adjustments and tweaks before settling down. Secondly, unless institutions are careful they can set themselves up for undue volatility in their allowance numbers. This would be an unwelcome outcome. This will be especially true when there is a change in the macro-economic environment. Surely, the allowance should take into account any such factors, but if the model and framework has not been calibrated and tested under such scenario during development, institutions will find it difficult to justify model changes just because the numbers are too volatile or are too high. Another area of challenge that we see is institutions struggling to find the right balance in terms of sophistication, avoiding making the CECL models neither a black box nor too simplistic.