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 current Allowance for Loan and Lease Losses (ALLL) accounting standard. CECL standard focuses on estimation of expected losses over the life of the loans, while current standard relies on incurred losses.

Background

Financial crisis of 2007-2008 demonstrated that ALLL credit losses accounting standard did not allow for timely adjustment of reserve levels based on reasonable expectation of future conditions. It relied 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 by CECL. CECL requires to estimate expected losses 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 OCC and Fed 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).

References