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Current Expected Credit Losses: From Theory to Practice

By Fayyaz Memon, Job Joseph April 2019   |   Brief   |   15 min read   |   Email this brief   |   Download
The current expected credit loss (CECL) standard closes the loopholes of the incurred loss method to calculate loan loss reserves. This paper explains the challenges financial institutions face to implement CECL models and the issues they may face once the standard is in effect.
Current Expected Credit Losses: From Theory to Practice

“Financial stability cannot depend on omniscient supervisors identifying and preemptively defusing any potential source of crisis; it requires safeguards that can help the system withstand the force of a severe storm, and tools the government can use to limit the damage.”

– Timothy F. Geithner
former U.S. secretary of the Treasury

The runup to CECL

In early 2000s regulators were lenient toward banks and regulations allowed banks to lend more. Unchecked lending and willful disregard for a borrower’s ability to pay led to the 2009 financial crisis. It also revealed that the growth of credit-loss reserves did not keep pace with the rise in loan growth1 (Figure 1). The five-year loan growth CAGR (2002-2007) was 9%, against 4% for loss reserves.

The crisis turned the tables on lending, and regulators placed strict checks. Interbank lending froze with minimal or almost no consumer lending activity. At the same time, the growth in loss reserves surged immediately post the crisis.

Figure 1. Loan growth outpaced loss reserve growth prior to the crisis (U.S., 1993-2006)

Loan growth outpaced loss reserve growth prior to the crisis (U.S., 1993-2006)

Investors increasingly became aware of the inherent risks of the incurred loss method to delay the recognition of credit losses until they meet the probable threshold at which a loss is incurred. Investors criticized it for being backward looking and restricting an institution’s ability to record expected credit losses.2 In fact, the loss allowance coverage was the lowest in 20 years at 1.15% (Figure 2). This prompted a need for a better, more accurate accounting standard to clearly reflect the state of loans.

Figure 2. Loss allowance coverage was the lowest in 20 years prior to the 2008 financial crisis (U.S.,1986-2018)

Loss allowance coverage was the lowest in 20 years prior to the 2008 financial crisis (U.S.,1986-2018)

Financial institutions are unique, with varied portfolios and different risk appetites. To overcome these dissimilarities, and to strengthen the financial system, the regulator has to ensure all institutions recognize and report an accurate projection of credit losses.

The Financial Accounting Standards Board (FASB) proposed the Accounting Standards Update Financial Instruments — Credit Losses, and its impact on allowance for loan and lease losses, that introduced the CECL methodology for estimating allowances for credit losses in order to address the weakness of the current incurred-loss approach. CECL expects banks to use historically data-driven credit-loss computation methodologies and to apply statistical modeling techniques where appropriate. The model looks to establish a clear, causal relationship between accounting and economics, and further strengthened with macroeconomic variables, risk factors, and credit losses.

Closing loopholes in the old standard

CECL will replace the present incurred loss standards — FAS-5 and FAS-114 — and will enable institutions to calculate losses using an expected loss method. The standard provides guidance on how entities should measure credit losses on financial assets held at amortized cost. The CECL measurement of expected credit losses encompasses relevant information on past events and experiences, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount.

The credit-loss estimation method is a major change from the current impairment model. CECL is proactive compared to the current reactive, incurred-loss computation.

The FASB states the new standard will improve financial reporting as it requires a timelier recording of credit losses.

Credit loss estimation under CECL

The standard expects banks to account for financial instrument losses from inception until the estimated life of the instrument or “life of loan” — the difference between the loan at amortized cost and the expected recoverable amount. However, the FASB only provides guidelines and gives institutions the flexibility to use any of the below methods to estimate credit losses, based on the size and complexity of their portfolio. The methods include:

  1. Roll rate: Credit losses are computed based on historic roll rates (migration from one delinquency bucket to another) against a portfolio.
  2. Vintage analysis: The portfolio is grouped based on the age of origination. Future losses are estimated on the back of average historical losses, with the macroeconomic outlook adjusted based on qualitative (Q) factors.
  3. Loss rate: Different pools are created within the portfolio segment. Future losses are estimated based on average historical losses against the pool.
  4. Probability of default: The default rate is computed using the lifetime probability of default (PD) and loss given default (LGD), for expected credit loss (ECL), against a static pool or for each account.
  5. Discounted cash flow: The present value of expected future net cash flows is used to compute losses. This method is applied at an account level.
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