Written by Bill Curtis, Partner
In July, Federal Reserve staff held an “Ask the Fed” webinar designed to introduce the Scaled CECL Allowance for Losses Estimator (SCALE) method, which is intended to assist in the process of calculating a compliant allowance for credit losses (ACL) for smaller community banks. The SCALE method was developed in recognition that many smaller community banks face operational burdens in capturing sufficient lifetime historical data and developing reasonable and supportable forecasts.
What is it?
The SCALE model is an Excel-based tool that includes the required components of CECL, including the use of a historical loss rate, current economic condition factors, and forecasted future economic factors. The model leverages public Call Report information to come up with an initial proxy expected lifetime loss rate as a “starting point” for the institution’s calculation of ACL. The primary advantage of the SCALE method is simplification, which results from substituting proxy data from peer-group institutions for bank-specific loss rates, alleviating the process of mining lifetime historical data.
Expected Lifetime Loss Rates
The SCALE method relies on proxy expected lifetime loss rates. The bank would calculate proxy expected lifetime loss rates by using data reported in the latest period on Schedule RI-C of the Call Report. This schedule collects the amortized cost and associated allowance balance for certain loan segments of banks with assets greater than $1 billion which have adopted CECL. Banks will be able to access this data to implement into their SCALE tool from the FFIEC’s Central Data Repository
It will be up to the institution to determine the appropriate peer group for computing expected lifetime loss rates. In some cases, a national average of all reporting banks may be appropriate. But, in most cases, a more personalized peer group would be more suitable.
A key advantage of using the peer data is the fact that the loss percentages will already incorporate the peer group’s evaluation of qualitative adjustments, reasonable and supportable economic forecasts, and estimated prepayments.
How do local economic conditions affect credit risk? Similar to practices under the incurred loss methodology, management must continue to consider qualitative factors that affect the collectability of their loans (and other assets within the scope of CECL) when using the SCALE method to estimate ACLs under CECL. For example, while reasonable and supportable forecasts are incorporated into proxy expected lifetime loss rates, management may believe that local economic conditions are expected to perform better or worse than the economic conditions impacting their peers. In this case, bank management should consider whether a qualitative adjustment should be applied to the proxy expected lifetime loss rates to better reflect the bank’s local conditions.
It is expected that bank management will use judgment to further adjust the proxy expected lifetime loss rates to reflect bank-specific facts and circumstances arriving at a final ACL estimate that adequately reflects their loss history and credit risk in their portfolio. During the webinar, the Federal Reserve noted they might expect to see reduced qualitative factors due to the peer data already incorporating this information.
Historical Loss Reconciler
Has the bank’s loss rate traditionally varied from national norms or local peer institutions? The SCALE method prompts for input of a bank’s net loss to average loan rate from 2007-2020 (Fed noted this was the current loss cycle time period) and also the UBPR peer groups net loss to average loan rate over the same time frame. These loss rates are available on pg. 7 of the bank’s UBPR. These loss rates are compared, and an adjustment is calculated based on the differences, essentially a historical loss reconciler. This adjustment can be positive or negative. This calculation is prepared on the portfolio as a whole; however, the regulators indicated it may be appropriate to expand this analysis and make specific adjustments for each individual loan segment.
Limit and caveats
Since the proxy expected lifetime loss rates would typically be based on information from the previous reporting period, there will be a lag between the proxy data and the reporting date (ex: September 30th Call Report information used in the December 31st SCALE model). Management is responsible for considering whether a qualitative adjustment is necessary to reflect any changes in economic and business conditions at the reporting date that affect the collectability of the bank’s loans that were not present at the time the proxy expected lifetime loss rates were calculated. This is particularly important during periods in which the economic environment is rapidly changing, such as the first quarter of 2020.
The SCALE method is not a regulator preferred method for estimating ACLs. The SCALE method is one of many acceptable CECL methods that a bank may use to estimate ACLs. However, like all other acceptable CECL methods, bank management needs to determine whether the SCALE method is appropriate for their bank.
Because the tool is prohibited for banks with more than $1 billion in assets, institutions contemplating an acquisition or approaching the $1 billion threshold should consider another method besides the SCALE option.
The SCALE method and provided tool hold the potential to make CECL compliance quite a bit easier for community banks. However, it is vital that bank leaders receive sound guidance in implementing and applying the tool such that it achieves the intended purpose of easier and more accurate credit loss allowances as well as complying with U.S. GAAP.
We encourage bank management to work with a qualified advisor in adopting the SCALE model to minimize risk to the bank and ensure full compliance with regulatory requirements. Reach out to your Mauldin & Jenkins advisor for assistance.