TCT Provides CECL Compliant Management Tools

By Dennis Child, Research Specialist, TCT Risk Solutions, LLC


Current Expected Credit Losses (CECL) will take effect for most credit unions in 2020 and is seen by industry experts as one of the most extensive regulatory changes affecting debt instruments to be implemented in over 30 years.   The near collapse of the financial industry and the “Great Recession” of 2008 highlighted the need for timelier reporting of credit losses.   Until recently,  Generally Accepted Accounting Principles (GAAP) advocated   financial institutions determine their credit weaknesses using an “incurred loss” approach, which requires recognition of a credit loss to be deferred until the loss is probable (or actually incurred).  Thus, there were concerns the incurred loss approach failed to alert investors about credit losses in a timely enough manner.  CECL takes a forward-looking approach to reporting, and reserving for, credit losses.  Even though credit unions do not have “investors” in the traditional sense, they are still expected to adhere to CECL standards.


CECL rules are expected to change fundamentally how credit unions, banks and other financial institutions calculate their credit loss reserves.  CECL is expected to alter credit operations as well. CECL encourages financial institutions to take a “forward-looking” approach to loan instruments and recognize possible credit losses earlier.  CECL will apply to loan commitments, financial guarantee contracts, reinsurance receivables, leases, trade receivables, as well as debt instruments. 


 CECL guidance is not prescriptive as to the specific model that should be used to meet the standards it sets forth.  Many in the financial industry are looking at three methods in particular: credit migration analysis, vintage analysis and probability of default/loss given default (PD/LGB).  We at TCT believe through experience and research that Credit Migration Analysis is the most useful and beneficial method for credit unions to forecast loan losses. That is why TCT has focused on providing one of the most effective Credit Migration management tools in the marketplace.


As stated above, financial institutions are expected to switch from an “incurred loss” methodology for reserving for loan losses to a method that is “forward-looking” (predicting the future).   Experienced managers know that predicting future events is troublesome and hazardous to say the least.  But, predicting the future using “forward-looking” methodologies for reserving for loan losses is the basis of CECL.  The challenge for managers in accurately reserving for loan losses using “forward-looking” approaches is in creating statistically valid and reliable models.  Through years of research and back testing, TCT has created a statistically validated and reliable Credit Migration model that predicts loan losses and establishes amounts to be set aside in Allowances for Loan and Lease Losses.


TCT’s goal is to identify causal links that can be used as predictors of expected outcomes (using stochastic methods to predict the future).  For the purpose of Credit Migration modeling outcomes, and predicting risk in loan portfolios, TCT examines loan losses.  Using statistically validated predictors, future events such as loan losses can be reasonably forecast.


Through years of research and using statistical methodologies including regression analysis, TCT has identified the following factors as the primary predictors of impending losses in loan portfolios:


• Deterioration of credit scores (60% to 80% of all losses are directly connected to deteriorating credit scores)

• Advanced delinquency (a loan with a  deteriorating credit score and falling delinquent is exponentially more likely to present a loss)

• Changing income affecting discretionary cash flow

• Changing economic conditions (relates to employment and cash flows)

• Loan to value-of-collateral ratios (the more a borrower has to lose through forfeiture of their collateral, the less likely they are to default)


TCT’s statistically back-tested and validated Credit Migration model provides a number of benefits for credit union managers:


Provides a better understanding of loan portfolios

  • Credit Risk can increase or decrease
  • A view into which risk pools are improving or deteriorating

Quickly identifies potential loan problems

  • Identify impaired loans and react to them early
  • Understand the risk in loan pools and adjust policies and procedures

Identifies opportunities

  •  Recognize members who practice good borrowing habits
  • Proactively offer ways to help members
  • As a strategic tool for determining loan pools to increase or reduce risk

Applying precision in ALLL calculations

  • Statistically based calculations
  • Complies with regulations


Surveys show that fewer than 25% of financial institutions including credit unions have even begun to prepare for CECL.  Opinions as to the impact CECL will have on credit unions vary from “non-event” to disastrous.  The actual impact will depend on how well a credit union is prepared for CECL.  Credit unions should be preparing now for the impact CECL may have on their loan loss placements and profitability.  


TCT’s Credit Migration model has been reviewed by CPA firms specializing in credit union regulations and found to be compliant with CECL.  Very few competitors offer loan loss prediction models that already meet CECL guidelines.


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