Current Expected Credit Losses

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 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).

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]