CECL is WARMing Up!
The FASB staff recently discussed the Weighted Average Remaining Maturity (WARM) methodology for reserving for credit losses as an acceptable approach to adopting CECL.
As the Current Expected Credit Loss (CECL) standard moves toward implementation (currently slated for fiscal years beginning after December 15, 2021 for non-public business entities), the answer to the question of “what will it look like?” is becoming clearer. In this case, the Financial Accounting Standards Board (FASB) staff, in their recent Q&A session on Credit Losses, discussed the Weighted Average Remaining Maturity (WARM) methodology as acceptable for CECL.
This method begins with an annual charge-off rate composed of several “vintages” as a foundation to estimate future credit losses. Similar to the allowance for loan loss calculations we see at many clients, it’s based on historical charge-offs against average loan balances. In their example FASB went back five years. They warn that the historical period vintages are subject to management’s determination of what’s appropriate based on underwriting standards, portfolio mix, loan terms, and economics.
The next step involves coming up with the weighted average life of loans. This involves dividing the loan portfolio into pools by remaining life, then multiplying that life by the total balance of loans in that pool divided by the total loan portfolio. The sum of those products is the weighted average life of the loan portfolio.
Finally, that weighted average is multiplied by the historic loss rate to arrive at an “unadjusted historical charge off rate” as it’s referred to in their example. The unadjusted historical charge off rate is applied to the total loans at the end of the period to arrive at the allowance. There is some room to modify the rate for qualitative factors as well. In real life, the calculation will be further enhanced by taking into account the loan categories and internal ratings as well. The way this method differs from what we usually see is that, by looking at the future payoff periods, it is taking a prospective approach in the calculation versus relying entirely on the historical rates and current balances.
We are currently developing a variety of basic CECL templates to distribute to clients and friends within the banking industry. We will continuously update the templates as we collect feedback from bank regulators and other experts. If you would like to use our templates as starting point in developing your own specific analysis, please contact us.
To link to FASB’s Q&A, please click here.