Effective CECL Adoption Timelines Confirmed: Expected Cost of Implementation

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1 WHTE PAPER Effective CECL Adoption Timelines Confirmed: Expected Cost of mplementation ncorporating Cost Analysis in the Overall Transition

2 The Argus team really knows their CECL stuff. Not only are they a pleasure to work with, but was impressed with their quant abilities and the process even helped me learn more about the capabilities of my bank s core system to address the data needs of CECL. Deb Evans, CFO Bank of Lancaster Kilmarnock, Virginia On Nov 11th, FASB decided the effective dates of adoption for the CECL guidelines. For staggering the dates of adoption for financial institutions (F) of various sizes, FASB took a different approach from asset size range and used the definition of public business entities (PBE). Dec. 15, 2018, including interim periods For PBEs which are SEC Filers Dec. 15, 2019, including interim periods For PBEs which are non-sec Filers Dec. 15, 2020, including interim periods For all other entities The final guidelines on CECL are expected in Q For the first adoption date, Fs have eleven quarters to take the necessary action for a successful transition. Given that even the regulators view the transition from the current incurred loss models to expected loss model as not just a tweak but a fundamental change, it is important for Fs to begin the impact estimation process early and plan for this change. n our previous paper Effective CECL adoption timelines confirmed: How to start preparing now we saw the steps an F needs to undertake for a successful transition. n this paper, we analyze the entire implementation process and define the cost items that need to be analyzed. Moreover, based on our previous comparable experiences, we have assigned a dollar value which is a function of size, complexity and implementation options to each cost item and we use this to take a look at overall indicative cost. mplementation Options Available FASB is trying to make things easier to understand and less complex to implement Do not rush into building CECL models as soon Three options available to banks for implementation: o Build n-house o Buy a vendor solution o Outsource entire calculation to a Third Party For any transition required for a regulatory change, Fs have three options: build in-house, buy a vendor solution or outsource to a third party. Option 1: n-house Build: The F decides to build the new models, create the infrastructure to acquire and store data from the source systems and perform all project management activities by itself. Option 2: Vendor Solution: The F buys a third party solution. For ease of understanding, we have assumed that it is a hosted solution rather than an on-premise one (to reduce the infrastructural. Option 3: Third Party Outsourcing: The F decides to outsource the entire process to a third party vendor where the F provides the files downloaded from the core system and the third party performs the calculation every quarter. Cost tems to Consider Each bank has its own set of complexities and diversities. An ideal yardstick to differentiate between the complexities is the size of the institution. We analyzed* a set of cost items that would remain constant, irrespective of the size of the bank and another set of cost items that would change with the size of the bank. 1

3 *Assumptions a) There are only three options available as mentioned in the previous section b) ndirect () costs are calculated based on time spent on an activity and Direct (D) costs are dollar amount allocated to an activity c) There might be a few cost items which are irrelevant to a few banks d) Cost of management time spent during business-as-usual and Cost of employee time associated with the ALLL calculation are included as an assumption e) Vendor solution and third party outsourcing vendors would provide pre-built CECL models with external data capability and prepayment inclusion option f) Capex: One time investment required by the F on transition to CECL; : Cost which the F is expected to incur on a yearly basis g) All are mentioned as expected expenses over a one year period h) Operational costs are forecast for a five year period i) The average one person day cost is assumed as $350 and the interest rate to discount future costs is 3% j) The cost of current ALLL is approximate and may vary from bank to bank k) There are no Capex costs involved in the current ALLL process Capex (one time (per annum Activity D/ Description CECL model inherently would be different from currently used historical loss rate Build Model method. Fs need to hire a risk analyst if similar model building capabilities are unavailable within the organization. The cost to build the CECL models (time spent by a risk analyst) is taken into account under this cost item. CECL would require banks to use external data. There are certain data points which External Data are unavailable in the core systems. The activity of identifying this data is a joint effort required with the core vendors and solution providers. The missing/external data identified has to be made useful for the CECL models. Pushing Missing / External Data Activities such as data cleansing, data validation and data transformation have to be into Model performed before the data can be made usable for CECL models. Solution Validation / Certification D The CECL models would be validated by external auditors or third party. With CECL, the reporting and documentation requirements during the audits and Audit & Examination examination would undergo changes. Fs need to put extra efforts to generate additional reports and documents during the regular audits & examinations. Regulations keep changing and Fs need to be on top of all regulatory changes. Fs Regulatory Change Management need to spend time not only to understand the regulatory changes but also how to implement them. ntroducing a new product line or introduction of new policies, might require changes Business Change Management to existing models. Though, this is not a regular activity but, for a better estimation it was considered as one of the operational expenses. External Data Subscription / Maintenance Management Attention D For external data, Fs might be required to subscribe to an external data provider or maintain the data in-house. The F would either pay annual/monthly subscription fees or spend effort to update/maintain the in house database regularly. The management not only has to put efforts to validate ALLL calculated on a quarterly basis, but also has to approve any changes to the models/processes based on regulatory or business changes. Current ALLL Option 1 Option 2 Option 3 Build model NA NA NA Capex (one time External Data Pushing Missing/External Data into Model NA NA Solution Validation / Certification NA NA NA Audit & Examination NA NA (per annum Business Change Management External Data Subscription / Maintenance NA ~2K NA NA NA Management Attention ~1K ~1K 2

4 Capex (one time (per annum Activity D/ Description Approximate time spent by nternal Transition Group (TG) on pooling, ALLL Project Management methodology confirmation, TDR and impaired loan policy, reporting and documentation and extensibility. The most important aspect of CECL transition. The Data Focus Group (DFG) works with the core system vendors to identify the data elements and history as required for all requirements laid down during the project management stage. A one-time activity to create a data cleansing algorithm, retrieval mechanism and Core to Model Linkage transformation logic to move core data into a credit mart to make it usable for all upstream requirements. Solution Set-up The cost of setting up a solution, if the financial institution decides to buy a vendor solution. nfrastructure Set-up D The cost of setting up hardware (e.g. infrastructure for a credit data mart if required). Or, if the core vendor charges you for setting up the interface to retrieve data. Operational Effort On a monthly/quarterly basis, data has to retrieved from the core system (directly/ interface). The core vendor might charge on a per file download basis. As CECL would require more collaboration between departments (business, risk, Ongoing Project Management finance, credit), the time spent on project management activities for sufficient flow of information across departments would be higher than current process. Quarterly Calculation and Validation The time spent on data validation, ALLL calculation/validation and approval. Ongoing nfrastructure Cost D Amount spent on database maintenance, core system interface maintenance, etc. Financial Statement Reconciliation Effort and time spend on building ALLL related disclosures (regulatory, internal, and Reporting board) and reconciling the financials with calculated ALLL. Solution Services Costs Subscription or service cost an F would incur if it goes for a vendor solution or third part outsourcing as an option. Current ALLL Option 1 Option 2 Option 3 Project Management NA ~2K ~2K NA 3K - 5K 3K - 5K Capex Core to Model Linkage NA Solution Set-up NA NA NA nfrastructure Set-up NA NA NA Operational Effort 3K - 5K 3K - 5K 3K - 5K 3K - 5K Ongoing Project Management ~1K 3K - 5K ~1K ~1K (per annum Quarterly Calculation and Validation Ongoing nfrastructure Cost ~2K ~2K NA NA Financial Statement Reconciliation and Reporting Solution Services Costs NA NA ~1K ~1K 3

5 deal Scenario: Overall Cost of mplementation deal Scenario is an important concept to understand before we take a look at the actual cost of a) f a bank decides to opt for an in-house build, the required skills to build the model are b) c) process itself. d) methodologies. e) F currently takes a monthly download of granular data (loan level) from the core systems.. Key Findings for Banks with Asset Size < $ 1Bn deal Scenario is an important concept to understand Compare the expected cost of spend Think about both Capex and A Few nferences: Current ALLL Option 1 Option 2 Option 3 ~25k ~39k ~35k ~33k on and core vendor discussions. available with a list of all data elements (required in the model). and keeping up to date with regulatory changes. 4

6 . Key Findings for Banks with Asset Size between $ 1Bn - $ 2Bn A few inferences: with asset size: < $ 1Bn: Outsourcing to Third party US $ 1Bn 2Bn: Outsourcing US $ 2Bn 5Bn: Buying Vendor US $ 5Bn 10Bn: Buying The on-going spend on future with a list of all data elements (required in the model). on and core vendor discussions. current spend keeping up to date with regulatory changes.. Key Findings for Banks with Asset Size between $ 2Bn - $ 5Bn 5

7 A Few nferences: on and core vendor discussions. with a list of all data elements (required in the model). data extensiveness and product richness of this segment. V. Key Findings for Banks with Asset Size between $ 5Bn - $ 10Bn A Few nferences: on and core vendor discussions. available with a list of all data elements (required in the model). 6

8 No bank is an ideal scenario bank methodology for current ALLL Focus Group (DFG) must study the contrast between the current state and the end state using the parameters below -. Data a) Once the F has decided on the pooling methods and what methodology suits which pool, it can refer to the data elements required for CECL and compare against the data to consider all data elements that have been sourced from core systems (ALLL, MS Rate your bank We expect an increase of around 2.0x-2.5x for a bank with very bank b) Check how much history is currently available. c) Check the quality of data available from core systems.. Process & Methodology a) b) be done for TDRs. c) require several changes to all reports pertaining to ALLL and if the current set-up is d) the scale. Based on the above comparison of the current state and the end state, Fs should rate themselves on a scale of 1 to 5 (1 being the lowest and 5 highest). Argus helped banks get this CECL readiness rating using a proprietary tool. We expect a maximum of 2x - 2.5x increase in cost from ideal scenario (2.5x for an F which rates itself 1 or below). 7

9 About the Author: Sourav Sekhar, Product Manager, Fintellix Solutions. Sourav is a Product Manager at Fintellix Solutions where he conceptualizes and drives the implementation of risk and analytics technology solutions for Banks. His product portfolio includes ALLL, Credit Portfolio Management and Regulatory Reporting. His extensive knowledge of banking operations, risk and technology helps design and deliver an integrated approach for automating and implementing solutions around regulatory requirements and strategic initiatives. His prior experience as an investment banker at Deutsche Bank and as a banking technology consultant for HSBC, Americas involved advising banks and financial institutions on M&Asand implementing core banking solutions. His perspectives have been published in prominent journals including Community Banking nsights, nternational Banker, Financial T, Analytics ndia Magazine and BFS Vision. Sourav is a Mechanical Engineer from the National nstitute of Technology, Warangal, ndia and an MBA in Finance from the ndian School of Business, Hyderabad, ndia. 8