Current Expected Credit Losses

Current Expected Credit Losses (CECL) is a new credit loss accounting standard (model) that was issued by the Financial Accounting Standards Board (FASB) on June 16, 2016.[1] CECL replaces the current Allowance for Loan and Lease Losses (ALLL) accounting standard. The CECL standard focuses on estimation of expected losses over the life of the loans, while the current standard relies on incurred losses.

Background

The financial crisis of 2007-2008 demonstrated that the Allowance for Loan and Lease Losses (ALLL) accounting standard does not allow for timely adjustment of reserve levels based on reasonable expectation of future conditions. It relies on losses that are incurred but not realized, i.e., when it is known with some certainty that future cash flows will not be collected. During the crisis, negative outlook of the economy was not taken into account for losses calculations. As a result, reserves were not adjusted for future expected losses. The FASB reviewed the standard and replaced it with CECL. CECL requires expected losses to be estimated over the remaining life of the loans, as opposed to incurred losses of the current standard.

FASB stated that the new standard will improve “financial reporting by requiring timelier recording of credit losses on loans and other financial instruments held by financial institutions and other organizations.”[2] The Office of the Comptroller of the Currency (OCC) and Federal Reserve predicted that industry allowances would go up by 30% to 50%.[3]

CECL impact

CECL is expected to have a substantial impact on multiple financial institutions.

  • Larger allowances will be required for most products. It is argued that this effect alone can change the structure of the products to scale down the impact.
  • As allowances will increase, pricing of the products will change to reflect higher capital cost.
  • Losses modeling will change. This will impact both data collection (data need to be more granular) and modeling methodology (backward-looking over a short period of time to forward-looking for the life of the loan).

CECL criticism

The Bank Policy Institute points out that CECL forces banks to recognize expected future losses immediately, but does not allow them to recognize immediately the higher expected future interest earnings banks receive as compensation for risk. This could result in a decrease in availability of lending to non-prime borrowers, stunting economic recovery following a downturn.[4]

Another criticism regarding CECL is that in order to estimate expected credit losses, banks are required to forecast the state of the economy. As noted by the American Bankers Association (ABA), “Forecasting is difficult, even for the experts… forecasting organizations largely missed forecasting the financial crisis and openly admit the difficulty in forecasting turns in the economic cycle.”[5] Additionally, CECL was implemented primarily to force banks to maintain countercyclical reserves. Per the American Banker, all thorough analyses of the effect of the new rules have shown, to differing degrees, that allowances will continue to be procyclical after CECL comes into force during 2020.[6]

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References
  1. "Joint Statement on the New Accounting Standard on Financial Instruments - Credit Losses" (PDF). Fed Law, Regulations. Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, National Credit Union Administration, Office of the Comptroller of the Currency. 17 June 2016. Retrieved 14 March 2018.
  2. "FASB Issues New Guidance on Accounting for Credit Losses". FASB press release. Financial Accounting Standards Board. 16 June 2016. Retrieved 14 March 2018.
  3. "FASB's Current Expected Credit Loss Model for Credit Loss Accounting (CECL): Background and FAQ's for Bankers" (PDF). ABA Backgrounder. American Bankers Association. June 2016. Retrieved 14 March 2018.
  4. "CECL Regulatory Capital Proposal Leaves Many Important Questions Unanswered". Bank Policy Institute. 25 March 2018. Retrieved 6 March 2019.
  5. "CECL Implementation Challenges: The Life of Loan Concept" (PDF). American Bankers Association. June 2016. Retrieved 6 March 2019.
  6. Tony Hughes (11 January 2019). "CECL is in trouble, but there's a fix". American Banker. Retrieved 6 March 2019.
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