By: The implementation of the new expected credit loss (CECL) standard on 1/1/23 has raised questions from regulators about the need for model validation. CECL replaces the incurred loss model and affects the calculation of the allowance for credit losses (ACL). Given the complexity of this calculation, many Financial Institutions (FIs) use third-party models, making it important for management and those responsible for governance to review and validate the methodology.
What is Model Validation?
Model validation involves verifying that a model meets its design objectives and performs as intended. The frequency and rigor of validation depend on the model’s complexity and risk, but there should be both an initial validation as well as ongoing validation activities. Validation should be performed by someone independent of the model’s development and should possess the necessary skills and knowledge to evaluate its accuracy.
Model Validation Expectations
The 2011 joint regulatory publication, “Supervisory Guidance on Model Risk Management” outlines best practices for model validation. Model validation is important for avoiding financial losses from incorrect or misused models. The ACL calculation is a FI’s most significant estimate, requiring vetting of the model to mitigate risk to the financial statements. Model validation will help ensure best practices are followed, a sound CECL model is implemented, and management makes informed decisions.
Beyond Regulatory Requirements
Model validation for CECL may be performed for regulatory compliance, but it also offers benefits such as ensuring accuracy, identifying limitations, helping understand the model and its outputs, and gaining insights into best practices and strategies used by similar FIs. Model validation is crucial for making informed decisions and ensuring sound CECL implementation.
Validation of CECL models should include, but not be limited to the following:
- Evaluation of conceptual soundness, including developmental evidence and management governance;
- Performing ongoing monitoring activities, including process verification and benchmarking;
- Analyzing model output, including backtesting.
The transition from the traditional incurred loss model to CECL can pose challenges from an implementation perspective. Validation of the model provides reassurance for the institutions that they are meeting regulatory requirements, adhering to best practices, and making informed decisions. Reach out to Kelly Shafer, CPA or Natalie Luppold, CPA, CISA, CITP, CRCM at Suttle & Stalnaker, PLLC for assistance with your CECL validation today.