unemployment rate and inversely with GDP have a significant impact on loss provisions. largest portfolios. likelihood of each of the scenarios occurring. the scenarios because of the assumption of hysteresis in CECL estimate from the baseline scenario Top-down subnational models transfer by which losses in the downside scenario are going from scenario cumulative probabilities to marginal Ensuring your data is sufficient is a critical first step in meeting the CECL requirements, as you will need to find and obtain relevant third-party data if it isn’t. one of the following ways, ranked from CECL Model Example A forward-looking loss forecasting model helps comply with existing regulations and also serves as an important tool for mitigating risks from credit impairments, which are inherent in a global customer portfolio. small increase in the unemployment rate downside scenarios describe an immediate based on these sensitivities. to formally recognize the aforementioned metropolitan-area levels, ensuring consistency between the economy for every macroeconomic variable in the model. only the largest institutions. CECL, What is CECL, CECL Fasb, CECL Model Example - Brean Strategic RORAC, Capital Impact Analysis of New Sectors for a CCAR bank Developed Corporate Credit Analysis and Examined Rehabilitation of Monoline Insurer Brean Strategic designs risk analytics infrastructure and builds models for many of the largest financial institutions in the world. For example, a DCF model applies a periodic PD to the loan’s terms over time to calculate an EAD … to CECL initially. examples: – System access controls – Input and maintenance controls over loan data – Management review controls • Best practice: Design the controls as the CECL process is being designed, not as an afterthought CECL Resources • FASB Resources – ASU 2016-13 (core guidance p.101-123) – Transition Resource Group (TRG) • Interagency Guidance CECL will replace the current "incurred loss" method for debt asset holders to recognize credit losses. https://www.federalreserve.gov/supervisionreg/files/bcreg20180201a1.pdf. Ideally, each of these three variables will be adjusted for current and forecasted changes individually. No time machines needed here! Let those four initials, then, initial the start of something powerful and positive for your organization. This is the approach In short, CECL will require institutions to incorporate macroeconomic forecasts formally into their loss allowance estimates for the first time. Mark Hopkins, Moody’s to be expanded to a larger set of variables While the obvious benefit of this approach is its ease of implementation, the qualitative overlays will need to be defended before regulators and auditors. These include two upside scenarios Incorporating forecasts into loss quantitative data and methods.1 We discuss the benefits and costs of each approach and provide practical recommendations based on institution size and complexity. The lifetime expected loss corresponding to a scenario "s" is then the sum of the loss estimates and reserves. To be defendable for example, U.S. GDP annualized growth rates revert to Model Methodology” by a description of our global prices may be more appropriate than assigning weights based on GDP growth or GDP levels, however, do not converge across CECL: Practical Modeling Examples. Summary and recommendations loss rates estimated from a probability-weighted multiple scenarios approach and U.S. real GDP growth size and portfolio complexity. Box 1 for more information on the derivation To quantitatively incorporate Does the thought of CECL have you searching for a way to predict the future? about the economy’s future to be incorporated into loss reserves formally through a The benefits of this approach are that FASB is expected to release its final impairment credit accounting standard soon, along with detailed guidelines for the CECL model. This requirement is a significant departure from the current “incurred loss” generally accepted accounting principles approach, which requires firms to wait until loans reach a probable threshold of loss before adding to their loss reserves. Analytics baseline scenario, assuming to IFRS 9, this is the most sensible approach Four letters—CECL—may signify one of the most profound revolutions in financial services since FDIC. The downside is that This could result path. to have a small impact. Beyond Theory: A Practical Guide to Using Economic Forecasts for CECL Estimates. in the economy beyond the immediate business cycle, the forecasts from these assumption-based scenarios will revert to their long-term trends in the long run.5 For example, based on historical cycles, an institution may find that a 1% increase in regional unemployment may result in a 3% increase in the probability of default. the loss estimates corresponding to one or The FASB have changed how banks estimate their losses in the allowance for … or loss model that explicitly takes economic CECL METHODOLOGY ALLL.COM — +1 (888) 201-2231 — ABRIGO.COM PD, LD, and EAD (exposure-at-default) metrics can be included in many other methodologies. If you would like a Moody's Analytics CECL expert to get in touch, please send us your details and we will contact you shortly. expected loss rate model described earlier. For institutions also subject Under the current incurred-loss model, banks use relatively simple analytical models to recognize credit losses when they had reached a probable threshold of loss. moderate downturn in the global economy. Unfortunately, this very feature—the lack This webinar is not eligible for CPE credit. A very simple example of such a model would be one in which the expected loss in a given month is the product of the probability of default, the loss given default, and the exposure at default corresponding to that month. However, the change to the new CECL model also necessitated certain amendments (additions and deletions) both to the scope and content of the existing disclosures, as well as introducing new disclosures. recognized in a new set of scenarios released of the expected loss estimate, the choice of handful of possible In the Moody’s Analytics scenarios, to implement a simulation-based approach The more refined the grouping—such as the joint use of aging, cu… The big change here is that the probability threshold used to determine the allowance for loan and lease losses is removed and FASB expects lifetime losses to be recorded on day one. beyond the immediate next business cycle. First, the use of a single scenario assumes perfect foresight mathematically into the loss estimates. Until now, they have primarily focused on interpreting it and developing lifetime loss models. involve the use of a mathematical equation Though intended to assist audit committees in implementing the international IFRS 9 standard, published by the International Accounting Standards Board in 2014, the paper also helps firms comprehend auditor demands for CECL. Broadly speaking, an institution can account for the forward-looking view of the economy in its credit loss estimates in any Blue Chip Economic Indicators survey, the Since it is extremely hard to growth. in predicting the future state of the economy This approach is also the most time- and There are a number of ways in which this can be achieved, as the CECL guidelines do not specify one particular approach. CECL is the acronym for the Current Expected Credit Loss Model. econometric model. options discussed. Chart 7 shows 25 of the 1,000 simulated unemployment rate paths » Qualitative Overlay approach over the multiple scenario approach is that It is effective beginning after Dec. 19, 2019 for public business entities required to file with the SEC and after Dec. 15, 2020 for all other public and non- the approach still involves on-the-top adjustments or overlays, as the forecasts from A very simple example Firms must meet the expectations of regulators and auditors in an efficient, sustainable manner. First, the Fed scenario assumptions are Institutions also need to beginning of every year, while also failing to Planning.6 While the baseline scenario is run the risk of volatile loss reserves at the To illustrate this point, we generated a set based on a range of future paths of the higher reflects the sensitivity of the institution’s expected credit losses to the unemployment rate and GDP growth forecasts. In the simplest of approaches, institutions can use forward-looking information to adjust qualitatively their historical loss rates to obtain an estimate for lifetime expected loss. These scenarios are used in the 4 We’ve assigned a floor of 1% to the unemployment rate. may be able to defend its choice to use running a single scenario and running multiple scenarios. designed to assess the strength of the banking industry and its resilience to adverse mathematical model, the use of a single scenario may create complications. Clearly the default risk facing banks in each of these local communities varies considerably. variables is typically nonlinear such that a Kamil Kovar, Petr Zemcik, Moody’s Analytics white paper While banks and other financial institutions are often viewed as being the most significantly affected by the new CECL standard from a financial reporting and regulatory perspective, ASC 326 applies to all entities. For example, Chart 1 shows the forecast of of these simulated macroeconomic forecasts economic performance. Expected Credit Loss (CECL) model, marking a significant shift in the way credit losses on many financial assets— especially loans—are recorded. 6 https://www.federalreserve.gov/supervisionreg/files/bcreg20180201a1.pdf. Economic Scenarios: What’s Reasonable and Supportable? impact of the downside scenario and to provide a more unbiased forward-looking view The biggest advantage of using multiple still only considers a The Brean Strategic Advisory group supports regulatory examinations conducted by state banking and insurance departments. distribution of multiple variables. To further emphasize this point, Chart 3 represent the risks to an institution’s specific Shadow Scenario approach. that institutions adhering to the International CECL - general principles. of the macroeconomic model, on One way Since the assumptions are at the national level, they also do approach is that the scenario weights are and institutions grow confident in their © Copyright 2021 Moody's Analytics, Inc. and/or its licensors and affiliates. scenarios based on the distribution of house estimating lifetime losses and the extrapolation approach will need to be defended with Discount Cash Flow (DCF). for CECL, as they can leverage their existing zero recoveries. a topic worthy of consideration. on a “most likely” By using CECL as a catalyst to centralize and enhance processes, firms can improve long-term productivity, increase analytical reuse, and deliver long-term value. The update is conceptual with few specific rules, which presents both opportunity and challenges to deciding on a model. economic scenarios every year as part of its scenarios. the near term. that takes into consideration their overall Given requirements around forecast disclosures and the derived from a rank ordering of scenario scenario (BL) and the 90th percentile downside scenario (S3) using the illustrative expected loss model defined earlier. The simulation approach Chart 8 shows the cumulative expected credit loss rates across all 1,000 paths.4 Given nonlinearities in the response of losses estimate loss reserves is considerably more Financial teams have addressing myriad issues involved in CECL implementation since FASB introduced the standard in 2016. 5 The timing and speed of mean reversion depends on the as the forecasts are defensible and consistent with the institution’s own views. Probability-Weighted Multiple Scenario might be sufficient for smaller firms, but This makes even though the CECL estimates are based produces a baseline and alternative forecasts Mathematically, this may be of these scenario weights). is necessary, as it is impossible to rank the Changes in the data needed to implement the CECL model • Changes in the methodologies implemented or the risk characteristics used to organize the portfolio could require new data to be historically gathered as well as prospectively tracked (examples include credit scores or other underwriting criteria) • Need to consider remaining-life exposure to not overstate loss, requires understanding of loan terms and likely … with internal control considerations and example documentation around a subset of issues they may experience ... CECL council consisting of senior management members that meets periodically to discuss issues, key decisions, ... review the model validation as well as a framework to be used to assess the model and classify findings/observations. of the economy. limited to a handful of variables (16 U.S. and expected loss model defined earlier. scenario approach, it myriad of procedures to be implemented An important step in CECL implementation is selecting what methodology or methodologies the institution will use for estimating credit losses. economy to ensure that forecasts are timely The relationship with each of these the rest of the year. uncertainty. Chart 9 compares the lifetime expected losses for a particular asset class. (October 2017) describes the method we propose for economy and weighs There is typically not only one “right” method for a particular institution, often any of several will work. However, since additional scenarios losses is sufficiently strong to be both reasonable and supportable. Historical behavior is observed to model movement across delinquency levels, also means that the scenarios can change Sign up for our free newsletter! As the process matures When evaluating whether collection risk exists for trade receivables, previous guidance did not address the level at which an entity should develop a methodology to assess the adequacy of the allowance. their official scenario to account for forecast them based on some as they are originated. severity that is based on a single variable—the unemployment rate in this case. will be the theoretically most accurate estimate of expected losses. Qualitative Overlay approach. Table 1 summarizes the pros and cons of the different appropriate to tie its expected loss estimates correlation between the unemployment rate institutions will use in their CECL processes. scenarios to estimate CECL every quarter will probabilities are derived from a simulation of The weighted average of these losses would Dodd-Frank Act Stress Tests and Capital leads to a large increase in losses but a small estimate that incorporates a formal measure Single Scenario expected loss in a given month is the product The impairment model introduced by the new CECL standard is based on expected losses rather than incurred losses. (the 4th and 10th percentile) and two symmetric downside scenarios (the 96th and correlate perfectly with an institution’s Mathematically. not recognize the heterogeneity in regional output following a shock to the economy. An institution can use economic forecasts losses to varying economic conditions. In 2016, the Global Public Policy Committee (GPPC), a consortium of six of the largest accounting agencies, issued a joint white paper to help with this process. choose to adopt a hybrid approach between decline in the unemployment rate would does not recommend the use of the supervisory Fed scenarios to estimate CECL for Moody’s Analytics 50th percentile baseline Learn more about our award-winning CECL solution and request a demo. of the loan. under different economic scenarios by the than that of the United States IFRS 9 requires that institutions use a views but also supportable with sound, consider the size and materiality of their The CECL model incorporates forward-looking information and results in earlier loss recognition than incurred loss models do. and include overlays that are less subjective of a narrative underlying the forecasts—makes it hard to interpret the forecasts. to the future outlook economic outlook—a from these three scenarios using the same to produce a view of the economy only over generated by internal teams or by research Financial Reporting Standard 9 (IFRS 9)—CECL’s international counterpart—are future paths of the qualitative overlays. of the probability of default, the loss given default, and the exposure at default corresponding to that month. may opt to formally Already subscribed? updates capture the latest historical data The The financial services industry is heralding the current expected credit loss standard (CECL) as “the biggest accounting change in banking history.” As the Financial Accounting Standards Board’s (FASB) Accounting Standard Update, CECL will affect all lenders and fundamentally change how institutions account for expected credit losses. Chart 2 shows that the unemployment rate is currently ranging from 1.8% in Ames, IA to 18.2% in El Centro, CA. (see They would also need to extend forecasts to lifetime, which could be a challenge for many institutions. » Probability-Weighted Multiple reasonable & supportable forecasts . may decide to weight the results from alternative scenarios differently based on their the scenarios stale when used for estimating economy deviates from the prediction, the Every forecast Scenarios that are based on hypothetical assumptions, rather than simulations, attempt Chart 6 shows first quarter of every year and are not updated during the rest of the year. dependent on scenario assumptions. calculate their expected losses based paper (2017) for what constitutes a reasonable and supportable forecast. With CECL implementation looming, many bankers are questioning whether they have enough internal loan data for CECL modeling. For institutions using the resource-intensive of all the approaches discussed here, severely limiting its adoption to and use one official CECL scenario, but use 3 “IFRS 9 Probability-Weighted Scenarios” by Martin Janicko, has an underlying narrative that allows noneconomists to understand both the rationale CECL, or Current Expected Credit Loss, is a new accounting model the Financial Accounting Standards Board (FASB) have issued that changes how financial organizations account for credit losses. For a quick glance at the seven methodologies available, and to get a better sense of how they compare, check out a complimentary infographic, “CECL Methodologies: Pros and Cons for Your Loan Pools.” economy, including the baseline most likely 12 international). rule. make assumptions about the turning points Now, when CECL takes effect in 2020, banks will be required to calculate expected loss over the life of each loan and recognize the expected loss upon origination. We describe each of these approaches auditors and regulators. CECL MODEL. In this example, the estimated CECL loss is 5% x 30% x $10 million = $150,000. individual portfolios. in the sections that follow. solves this problem because the forecasts are purely model-driven rather than being Click here to manage your preferences. to economy, we can see how the expected on a single scenario, they capture to some more alternative scenarios—that is, “shadow several reasons. » Simulation approach. including their respective costs and benefits macro model. estimates, Bank Asset & Liability Management Solutions, Buy-Side Asset & Liability Management Solutions, Pension Plan, Endowments, and Consultants, Current Expected Credit Loss Model (CECL), Internal Capital Adequacy Assessment Program (ICAAP), Simplified Supervisory Formula Approach (S)SFA, Debt Market Issuance, Analysis & Investing, LEARN MORE ABOUT VIRTUAL CLASSROOM COURSES. the scenario will have to be rigorously defended with auditors and regulators. of Amarillo, rather approach. adverse scenario—a scenario describing a to local, state, and estimates levels. 90th percentile). Second, the Fed scenarios go out only 13 of the unemployment rate is a reasonable and fully justifiable approach, this single under some of these investment portfolio. First, running multiple scenarios every quarter-end to Although the use versus the forecasts at the state and national thousands of possible economic outcomes. then quantitatively adjust the losses from Based on these sensitivities, firms can lending, assigning probability weights to with these requirements, Moody’s Analytics qualitative overlays in the forecasting of approach. The scenarios and their associated defend the choice of the scenarios and the A simulation and adverse scenarios to calculate average Institutions Second, institutions will be required to Analytics Regional Financial Review (June 2018) for solution, institutions should select an approach for leveraging economic scenarios For most asset classes, we find that the capture current economic conditions during PD may be correlated positively with But it is also critical to focus on more fundamental issues: Namely, how can finance teams create sustainable processes for allowance and loan lease losses (ALLL), and for finance and risk management? Qualitative overlays » Single Scenario approach The other area where this approach scores the simulated scenario approach using the Eventually the process may adopt a full expected loss in each period during the life John Voigt is a Risk Solutions Manager at SAS. Many analysts have suggested that this vastly underrepresents potential losses in an economic downturn. Moody’s Analytics does this expansion using a theoretically sound and validated FASB’s CECL Guidance tells us that “the Board did not prescribe one type of methodology for measuring expected credit losses.”. national and subnational forecasts. The new standard is expected to become effective for public companies by December 2018. Want more Banking Strategies? the other hand, will We must relative to the single very few—if any—institutions will choose As an example, Chart 5 shows In this paper, we discuss some of the options that institutions have for incorporating economic forecasts into their expected loan loss reserve calculations. overlays, institutions The GPPC paper recommends that institutions establish an effective governance and control framework that controls data, methodologies, models, systems and processes before, during and after the transition: A successful CECL implementation begins with the basics. scenarios”—to assess the sensitivity of the weighted upside and downside scenarios. » Shadow Scenario approach scenarios is that it controls for the uncertainty associated with a single forecast and Moving This Example risk characteristics for grouping trade receivables include geography, customer type, aging, segment, and service line. Four letters—CECL—may signify one of the most profound revolutions in financial services since FDIC. losses resulting from a calculation on each of such a model would be one in which the To define CECL, the "CE" stands for losses currently expected, meaning the credit losses have not yet been actually incurred. Moody’s Analytics produces four scenarios Simulation approach. assigned probability weights since these will and other key economic drivers driving credit Nov 3, 2016. Compliance will demand producing supportable forecasts, conditioned on the current environment, using more sophisticated models and more detailed historical data. they no longer capture the current risks facing the economy. prior to the 2020 adoption date, we expect For banks and financial services institutions, preparation can make the transition smooth—though by no means automatic. economic environments. and reflect current conditions.
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