CECL, which stands for "Current Expected Credit Losses," is an accounting standard that addresses how financial institutions recognize and measure credit losses for financial instruments. It was introduced by the Financial Accounting Standards Board (FASB) in the U.S.
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The adoption of CECL was mandated by the FASB through the issuance of Accounting Standards Update (ASU) No. 2016-13, "Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments." This standard requires financial institutions to recognize expected credit losses over the entire life of the instrument, rather than waiting until it's probable that a loss has been incurred, as was the approach under the previous guidance.
Given that FASB sets Generally Accepted Accounting Principles (GAAP) for entities in the U.S., CECL is indeed a requirement under U.S. GAAP for applicable entities. Public business entities, not-for-profits that have issued securities that are traded, listed, or quoted on an exchange or an over-the-counter market, and certain other entities began adopting CECL in fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Other entities have later effective dates.
It's worth noting that CECL is a U.S. GAAP-specific approach, and entities reporting under other accounting frameworks, like the International Financial Reporting Standards (IFRS), would follow different models, such as the Expected Credit Loss (ECL) model under IFRS 9.
CECL was implemented to address some of the perceived shortcomings in the previous incurred loss model, especially in light of the 2007-2009 financial crisis. Here are some good and bad aspects of CECL and its implications:
Good Things About CECL:
- Forward-looking Approach: CECL requires lenders to estimate expected credit losses over the life of a financial instrument, not just based on past events. This encourages a more proactive approach to risk management.
- Better Risk Sensitivity: By incorporating a broader range of information, including macroeconomic factors, CECL allows for more accurate and timely recognition of credit risks.
- Eliminates Thresholds: The previous incurred loss model required a triggering event to recognize losses. CECL eliminates these thresholds, resulting in a more timely recognition of losses.
- Enhanced Transparency: CECL requires more detailed disclosures, providing stakeholders with a better understanding of the credit risks associated with financial assets.
Bad Things About CECL:
- Increased Volatility: Due to the forward-looking nature of the model, expected credit loss estimates may be more volatile, especially in times of economic uncertainty. This can impact a company's financial statements and capital planning.
- Operational Challenges: The implementation of CECL requires significant changes to data collection, modeling, and internal controls. This can be resource-intensive for institutions, especially smaller ones.
- Potential Reduction in Lending: There are concerns that the forward-looking nature of CECL might make lenders more conservative, particularly in a downturn, potentially reducing credit availability.
- Earnings Impact: Because of the upfront recognition of expected credit losses, there might be a significant one-time adjustment in many banks’ financial statements, impacting their capital and earnings.
Implications of CECL:
- Capital Planning: CECL's impact on earnings and capital will require institutions to adjust their capital planning and stress testing processes.
- Pricing and Product Offering: Financial institutions might adjust the pricing of certain products to reflect the changes in the recognition of credit losses. This could impact the availability and pricing of credit to consumers and businesses.
- Enhanced Risk Management: With CECL's focus on forward-looking information, institutions will likely enhance their risk management tools, processes, and governance.
- Greater Regulatory Scrutiny: Regulators are likely to pay closer attention to the methods and assumptions institutions use to calculate expected credit losses under CECL.
In conclusion, CECL represents a significant paradigm shift in credit loss accounting. While it brings more accuracy and transparency to the process, it also presents challenges and implications for financial institutions in terms of operational adjustments and potential market impacts.
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What are Credit Losses?
Credit losses refer to the losses that a financial institution incurs when borrowers do not repay their loans or other financial obligations as agreed. In other words, a credit loss represents the amount of money that is written off because it is no longer expected to be recovered from a borrower.
For financial institutions, such as banks, credit unions, and other lending entities, credit risk is an inherent part of their business. When they lend money, there's always a risk that the borrower may not be able to repay the loan in full or on time.
Here's a more detailed look:
Types of Credit Losses:
- Actual Loss: This is the amount that has already been written off by the bank because it has deemed that the funds can't be recovered. For example, if a borrower defaults on a $10,000 loan and the bank can only recover $6,000 after selling the collateral, the actual loss is $4,000.
- Expected Credit Loss: This represents an estimate of potential future losses on loans or other financial instruments. Banks use statistical models, past experience, and other relevant information to estimate expected credit losses. The introduction of CECL (Current Expected Credit Loss) standard has made it more forward-looking, requiring banks to estimate expected losses over the entire life of a loan.
Implications for Financial Institutions:
Provisioning: Financial institutions set aside funds as provisions for expected credit losses. These provisions are an expense that reduces the institution's net income. If actual losses turn out to be higher than expected, additional provisions may be needed. If they are lower, some of the provisions may be reversed, boosting profits.
- Capital Adequacy: Credit losses can impact a bank's capital adequacy ratios. Higher losses can erode a bank's capital, potentially endangering its financial stability.
- Pricing: Institutions must account for expected credit losses when pricing their loans. If a bank expects higher default rates in a particular sector, it might charge higher interest rates to borrowers in that sector to compensate for the added risk.
- Risk Management: Managing and mitigating credit risk is a central part of a financial institution's operations. This includes setting lending criteria, monitoring loan portfolios, and taking actions (like diversifying the loan portfolio) to reduce potential credit losses.
- External Factors: Economic downturns, rising unemployment, or events like natural disasters can increase credit losses for financial institutions. Hence, these entities often use stress testing to assess how their portfolios might perform under adverse conditions.
Credit losses represent the non-recovery of lent funds due to borrower defaults or other adverse events. Financial institutions must carefully manage and account for these losses to ensure their own financial stability and to comply with regulatory standards.
Here's how banks can comply with the CECL accounting standard:
Data Collection and Management:
- Assemble historical data on loan performance, including data on defaults, recoveries, prepayments, and more.
- Establish systems to gather relevant forward-looking information, including macroeconomic data that might impact the performance of loan portfolios.
- Ensure data quality and integrity, which is critical for reliable modeling.
Develop or Update Credit Loss Models:
- Use historical data to develop statistical models that predict the likelihood of default over the life of a loan.
- Incorporate forward-looking information to adjust model outputs based on expected future conditions.
- Different types of financial assets (e.g., mortgages, auto loans, credit cards) may require different modeling approaches.
Governance and Controls:
- Establish robust governance structures to oversee the implementation and ongoing use of CECL models.
- Develop internal controls to ensure that the processes related to CECL (from data collection to model application) are reliable and consistent.
- Set policies and procedures for periodic model validation and recalibration as market conditions and portfolio characteristics evolve.
Impact Assessment:
- Assess the capital and provisioning impacts of the transition to CECL. This might lead to an increase in credit loss allowances, which could impact capital ratios.
- Understand the potential volatility in earnings due to the more dynamic nature of expected loss calculations under CECL.
Disclosure:
- Enhance financial statement disclosures to provide stakeholders with a better understanding of credit risk exposure and the methods used to calculate expected credit losses.
- Regularly disclose the assumptions, inputs, and techniques used in credit loss models.
Training and Communication:
- Ensure that relevant staff, from risk management professionals to those in financial reporting roles, understand the CECL standard and its implications.
- Communicate with external stakeholders, including investors and regulators, about the bank's transition to CECL and the impacts on financial statements.
Regular Review and Updates:
- Continuously monitor loan portfolios and update credit loss estimates as necessary.
- Periodically review and recalibrate models to ensure they remain accurate and reflective of current conditions.
- Address any feedback or concerns from auditors or regulators.
Scenario Analysis and Stress Testing:
- Incorporate CECL methodologies into the bank's stress testing framework.
- Analyze how credit loss estimates might change under various adverse economic scenarios.
Technology and Systems:
- Depending on the complexity of the institution and its portfolios, banks might need to invest in new systems or software solutions that can handle the data and modeling requirements of CECL.
Collaboration with Auditors:
- Work closely with external auditors to ensure that CECL methodologies, assumptions, and resulting estimates are reasonable and comply with the standard.
