NCUA’s recent addendum related to CECL model validations

In Jan. 2024, the National Credit Union Administration (NCUA) issued an addendum to the Other Supervisory Committee Audit Minimum Procedures Guide, which was originally dated Jan. 8, 2020, that replaced procedures based on recent changes in the accounting standard related to FASB Accounting Standards Codification (ASC) 326, Financial Instruments – Credit Losses, commonly known as Current Expected Credit Losses (CECL). The original guide and current addendum provide Credit Unions with the minimum procedures designed to asset supervisory committees, internal auditors, or other qualified persons in completing the areas of review outlined in NCUA regulation part 715, Appendix A, Supervisory Committee Audit – Minimum Procedures. 

All credit unions with assets of $10 million and more were required to adopt CECL for financial reporting after Dec. 15, 2022. The current addendum replaces procedures from the original Procedures Guide, dated January 8, 2020, surrounding CECL and related to investments, loans and leases portfolio, and off-balance sheet credit exposures. This article describes the updated procedures related to a model validation of the Allowance for Credit Losses on Loans and Leases (ACL) as part of the annual audit requirements.  

The NCUA addendum states (among other things) that credit unions must obtain the following documents when reviewing the CECL methodology: 

• Schedule of the ACL movements, for the testing period which includes beginning balance, total credit loss expense, charge-offs, recoveries and ending balance.
• Detailed listings of charge-offs and recoveries by month.
• Management’s support of the ACL calculation.
• Board of Directors approved ACL Policy.
• CECL model—The simplified CECL tool, third-party CECL tool, or internally developed models for the periods under audit.
• CECL model documentation—Documents the major assumptions, inputs, and outputs of the CECL model. This documentation should include model validation and may also include model back-testing.

The addendum describes procedures based on the CECL model that the credit union implemented as part of adoption. More specifically, the Addendum includes a requirement that credit unions that use a third-party or internally developed CECL tool have their CECL model validation performed as part of its annual audit procedures.  For internally developed models (i.e. excel-based models), credit unions must confirm that an “independent validation is performed by individuals who do not have a role in determining the ACL value. This validation can be performed by individuals internal or external to the credit union.” Additionally, for all third-party models (i.e. software), credit unions must obtain an external validation of the third-party model.  

Model validation is the set of processes and activities intended to verify that models are performing as expected and in line with their design objectives and business uses. An effective model validation challenges the model’s data, design, assumptions, and estimates, assesses if proper governance has been established, and finally back-tests the assumptions to actual performance. All model components from the front-end model governance to the back-end reporting analytics and everything in between (data inputs, assumptions, forecasting) should be part of the validation process. SR 11-7 describes the key elements of a comprehensive validation as: 

• Evaluation of conceptual soundness: assessing the quality of the model design and construction as well as the documentation supporting the methods used and variables selected.
• Ongoing monitoring: confirming that the model is appropriately implemented and is being used and performing as intended.
• Outcomes analysis: comparing model outs to corresponding actual outcomes.

Additionally, model validations should be implemented on an ongoing basis to allow management to identify new potential risks and limitations as the organization and the economic landscape continue to evolve over time. As part of the updated Addendum, the NCUA is stating that credit unions have their CECL models validated as part of the annual audit requirements as the risks associated with CECL model results have a larger possible adverse impact to the financial institution’s financial statements than other regulatory required models such as ALM, BSA/AML or Fair Lending that may be validated on a less frequent basis and do not directly impact entity’s financial statements. 

Baker Tilly model validation specialists have completed several hundred CECL model validations since CECL was introduced and our approach adheres to all applicable model validation frameworks described above. Aside from checking the regulatory box, our model validations provide insights into the model and its processes, model governance and internal controls to help our clients identify data issues or gaps and user challenges and enhance transparency of the model functionality. Additionally, we provide recommendations to strengthen current CECL frameworks to align more strategically with the financial institution operations. Management and users of CECL models can gain full confidence in the model that was chosen and its appropriateness to their institution.  

Key takeaways from our comprehensive model validation include: 

• Model governance, documentation, internal controls, and qualitative factor frameworks are just as important as the CECL estimate. Credit Unions need to own the assumptions and the development and application of those assumptions inside and outside of the model. 
• Data extract, transfer and load processes need to be re-evaluated on an ongoing basis to ensure correct mapping of contractual data inputs into the model, especially on cash flow specific CECL models.  
• Sensitivity analyses, back testing and stress-testing of key assumptions should be implemented on an ongoing basis to identify impacts of changing economic landscapes to the bank’s future CECL estimates.