Article

CECL implementation: Why the discounted cash flow method could be right for your institution

Jan. 7, 2022 · Authored by Ivan Cilik, Matt J. Nitka, Sean Statz

Even though the effective date isn’t until 2023 for the current expected credit loss (CECL) requirements, financial institutions are already working to implement necessary processes to adhere to the new accounting change. The standard is such a significant and extensive change that many institutions are having to start from scratch in order to realize their data requirements, multiple methodologies, forecast considerations and validation needs.

One of the most critical parts to complying with CECL is determining a methodology for measuring the allowance for expected credit losses. Institutions have several methodologies to choose from, and some are better for certain products than others, which means institutions may need to use a variety of methods because they have a number of different products. Methodologies range from “SCALE” and “WARM” methods, which are more popular with smaller institutions, to more complex ones, like the discounted cash flow (DCF) method, which tends to be favored by larger institutions. That being said, the amount of data and the resources an institution has will most likely be the determining factors in steering management toward one direction or another.

Fortunately, institutions should be able to leverage their existing processes or models when selecting their CECL model and building efficiencies into their implementation process. For instance, many asset liability management (ALM) models are already running a DCF approach on loans, bringing in the contractual information and running out the cash flows over the life of the loan. Through the ALM process, institutions are already extracting and vetting data that could then be used for their CECL methodology as well.

It is worth noting that the DCF method is considered more complicated than the others, but that doesn’t matter if it is the best method for your institution’s needs.

DCF basics

The standard for the DCF method essentially says that if an institution is using a cash flow approach, the discount should be at the financial asset’s effective interest rate. “When a discounted cash flow method is applied, the allowance for credit losses shall reflect the difference between the amortized cost basis and the present value of the expected cash flows,” it further states.

But what is DCF? It is often considered the most complicated method because it projects cash flows over the life of the loan, particularly longer-term loans, e.g., 30-year mortgages. Cash flows are behaviorally and credit adjusted before discounting at the loan’s effective interest rate. Its projections are taken from several sources. In fact, the DCF method draws heavily from institutional information, requiring access to current data at the instrument level — on the institution’s loans and investments — as well as historical data, to get an accurate read on trends and behaviors. This works best for longer-standing products that have many years of supporting documentation. Newer products that have only accumulated a few years of data may be better off using a simpler method. However, after data has been collected for several years on that product, the institution can merge the two methods.