The Current Expected Credit Loss model is a regulatory requirement where institutions must record the estimated lifetime credit losses for loans, leases, and debt instruments starting on day one. Although adoption of these requirements does not begin until 2020, and effective adoption is not until 2022 and 2023, data collection should begin now in order to successfully prepare for implementation.

This new accounting approach sprung out of a review of the 2008 financial crisis. Research highlighted that loss recognition prior to the crisis was delayed, and, resultantly, Allowances for Loan and Lease Losses (ALLL) balances were deficient anywhere between 30–60%. In response, the Financial Accounting Standards Board (FASB) formed the Financial Crisis Advisory Group to investigate new options. Thus, the CECL Model took shape, replacing the previous “incurred loss model” with the new “expected credit loss model”:

In addition to forecasting losses at the origination of the loan, the CECL model also requires impairment of existing financial assets on the basis of current estimates of contractual cash flows not expected to be collected by the reporting date. Essentially, at each reporting period, the expected losses will be recalculated, and any changes will flow through earnings.

Losses will be based on current risk ratings and historical loss rates for similar assets, and they will be adjusted for any changes in current conditions or future expectations. The resulting allowance does not relate to any specific asset, but rather relates to pools of assets with similar characteristics.

Making the operational transition to CECL will be a significant undertaking. CECL Pro’s levels of detail and understanding can provide peace-of-mind in implementation and application.

There are several key dates for this new regulatory requirement:

• December 15, 2018 – early adoption is permitted for all organizations.
• January 2020 – implementation is required for public business entities that are SEC filers.
• January 2023 – implementation is required for non-SEC filing public businesses as well as for all other entities and not-for-profit organizations.

The current “Incurred Loss Model” utilizes an incurred or probable threshold for losses. This is based upon occurrences in the past as well as current conditions that likely caused the impairment.

The “Expected Loss” model does not require any threshold; instead, it looks forward over the entire lifetime of the loan and is based upon past events, current conditions, and reasonable and supportable forecasts.

The CECL model applies to loans, Held-to-Maturity (HTM) securities, net investments in leases, and off-balance sheet items such as loan commitments, standby letters of credit, and financial guarantees.

The CECL model does not apply to assets measured at fair value, including Available-for-Sale (AFS) securities and loans held for sale.

Although implementation is not required immediately, your institution should start planning today by understanding the data requirements, collecting data, documenting methodologies and assumptions, and forecasting impacts to future capital. Evaluating upcoming annual budgets, educating the board, and forming an Implementation Committee is also smart.

Current tasks which could prove helpful include tracking losses and recoveries by specific product type (e.g., new auto direct, new auto indirect, 15-year mortgages, 30-year mortgages), as CECL will be a smoother process if losses and recoveries are tracked at the product level, and by continuing to refresh FICO scores, debt-to-income (DTI) ratios, and loan-to-value (LTV) estimates.

There is not a specific look-back period requirement. However, as a rule of thumb, the look-back time period should be at least equal to the average remaining life of the portfolio/segment. Ideally, the institution would utilize data from the past decade in order to incorporate before-and-after financial crisis data.

No, FASB does not explicitly require any specific calculation model. Different methods ALM First considers and can utilize include a discounted cash flow analysis, average charge-off method, vintage analysis, static pool analysis, migration analysis, and probability-of-default method.

The CECL model applies the effective interest rate (the book rate at origination adjusted for any net deferred fees, costs, premiums, or discounts) as the discount rate. Doing so applies the same credit indicators (FICO, term, LTV, etc.) the institution used when underwriting the loan. Moreover, this valuation is not intended to represent fair market value, but rather highlight future expected losses.