Current Expected Credit Loss (CECL)
CECL approach to setting the loan loss allowance comes to us from the 2008 financial crisis in which financial institutions (“entities”) lacked adequate loan loss reserves and capital to weather the crisis. As a result, both regulatory and external auditors began to give heightened scrutiny to the recognition of credit losses.
The Financial Accounting Standards Board (FASB) also began deliberating about the recognition of expected credit losses and promulgated Accounting Standards Update (ASU) 825-15 (Financial Instruments – Credit Losses) to address improve reporting. Although this work had been done initially in conjunction with the International Accounting Standards Board (IASB), diverging views on computing the expected credit loss (ECL) ended up leading to two different reporting methodologies.
CECL requirements will change how entities think about their Allowances for Loan Losses (ALLL).
- The CECL approach is not based on a worst or best case loss forecast: The allowance is to be set based on the expected one.
- Financial products which must be considered include: debt instruments, loan commitments, and lease receivables.
- Calculations cannot combine debt instruments with other instruments which would offset credit loss, e.g., credit default swap to offset loan risk.
- For the relevant products, the CECL is given as the Expected Credit Losses (ECL) based on reasonable forecasting starting today and continuing over the lifetime of the product.
- The ALLL then becomes the CECL over all (applicable) financial products.
- The adoption of the CECL approach will result in substantial increase in loan loss reserves.
Financial institutions must comply with CECL reporting rules in the next few years. The conversion to CECL involves these phases:
CECL Implementation Timetable
Publicly held financial firms which are SEC filers must use CECL reporting for all fiscal years beginning afterDecember 15, 2019 as well as for all interim reporting periods within those fiscal years.The implementation deadline for all other financial entities is the first fiscal year after December 15, 2020. CECL reporting must also be used for the interim reporting within that fiscal year and subsequent ones.
- The design, development, testing and implementation of the database and models/system to support CECL are complex and time-consuming.
- Bank regulators typically expect at least a six-month parallel run when material changes are made to how a financial institution sets its allowance for loan losses.
- Prescio recommends that all such institutions begin to work on CECL compliance at least 18 months before the start date.
- Optimally, in order to avoid the perils of a rushed project, banks and other entities should begin work 24 to 30 months before implementation.
Possible CECL Approaches
Some of the existing models used for computing CECL include:
- Loss Rate Models
- Rating Transition
- Roll Rate
- Cohort Models
- Static Risk Pool
- Average Charge-off
- Scalar Adjustments
- Discounted Cash Flows
The Prescio Difference
Prescio has a long history in developing and implementing models to support the calculation of the loan loss allowance.
- Almost 20 years of experience in designing, developing, implementing, and operating Loss Rate Models, especially PD/LEQ/LGD/EAD for major commercial banks.
- Intimate familiarity with the hazards of using a cookie-cutter modeling approach which does not address the unique data situations of each banking client.
Prescio has unique approaches to ensuring reliability in its models and their use.
- Prescio’s CECL application provides a one-step allowance setting model to use as a reasonability check on the final allowance factors.
- Prescio has a separate Loan Quality Forecast (LQF) application to facilitate setting the loan loss allowance at the end of each period.