Current Expected Credit Loss

From Open Risk Manual

Definition

Current Expected Credit Loss (CECL) is a financial reporting standard developed and approved by the Financial Accounting Standards Board (ASB), an independent, private-sector body that develops and approves Financial Reporting Standards in the US. It replaces the current standards for loss accounting - commonly known as FAS-5 and FAS-114. The FASB first embarked on the project to improve the financial reporting of credit losses on financial instruments in 2008. Since that time, the FASB has issued three documents for public comment.

The objective of CECL is to establish principles for the financial reporting of financial assets and liabilities that will present relevant and useful information to users of financial statements for their assessment of the amounts, timing and uncertainty of an entity’s future cash flows. Alongside disclosures mandated by regulators (e.g. Basel Pillar III reporting requires for regulated banks) these financial statements are the main source of information about the balance sheet of a financial institution.

Motivation

CECL was issued in response to the mandate received from the G20 in the light of the performance of accounting standards during the global financial crisis.[1] The new standard specifies a fuller and more timely recognition of credit losses, thus enhancing both the size of loss-absorbing allowances and their responsiveness to information pointing to a deterioration or improvement in credit risk.

Status

The ASU on credit losses will take effect for U.S. Securities and Exchange Commission (SEC) filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019. For public companies that are not SEC filers, the ASU on credit losses will take effect for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years. For all other organizations, the ASU on credit losses will take effect for fiscal years beginning after December 15, 2020, and for interim periods within fiscal years beginning after December 15, 2021.

Risk Management Implications

The introduction of the CECL standard has significant repercussions for bank Risk Management as it requires:

  • Embedding forward looking risk assessments in the measurement (assessment) of the firm's financial condition
  • Disclosing such assessments to external stakeholders

While the transition to the CECL approach requires a significant investment in new models, the adoption of CECL could benefit banks by improving their internal credit risk monitoring systems. While banks currently using the advanced internal ratings-based approach (IRB) to establish their capital requirements can adjust their models, banks solely using the standardised approach (SA) to determining their capital requirements may need to develop models from scratch

Scope

The scope of the CECL standard is quite broad: it is to be applied by all entities to all types of financial instruments with the exception of a prescribed list that includes[2]

  • interest in subsidiaries, associates and joint ventures
  • rights and obligations under leases
  • employer benefit plans (pensions)
  • own equity type instruments (including stock options and warrants)
  • underwritten insurance contracts (except for financial guarantees)

Issues and Challenges

  • Challenges related to the lack of data or experience relevant to the required ECL modelling
  • Role of managerial judgement and discretion in the ECL modelling process
  • Significant cost in terms of modelling, IT infrastructure, data gathering and dedicated human resources before the first application and subsequently on ongoing basis
  • Interaction of accounting provisions with capital requirements and implications for Pro-Cyclicality

See Also

References

  1. ESRB, Financial stability implications of IFRS 9, July 2017
  2. IFRS Standard 9, Financial Instruments, Chapter 2.1

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