In this Article
- What is CECL and Why Does It Matter?
- How does PrecisionLender Handle CECL?
- How are the approaches to Loan Loss Reserve Similar in PrecisionLender and CECL?
- Implications From an Accounting Perspective
What is CECL and Why Does It Matter?
In 2016, the Financial Accounting Standards Board (FASB) issued guidance on Current Expected Credit Loss (commonly known as CECL), which requires that the expected losses for the “life of the loan” be recorded at origination. This practice is in line with international accounting standards and the IFRS9 requirements. But it’s a big change from the traditional method that banks and credit unions use to record impairment charges for loans and other financial assets.
The goal of this change is to reduce the typical cyclical nature of credit cycles. Prior to CECL, the provision methodology involved recognizing loan loss provision as impairment happens. By provisioning for expected future losses, CECL creates more of a buffer which should stabilize both earnings and capital throughout the credit cycle and mitigate future situations like the Great Recession.
How does PrecisionLender Handle CECL?
Many of our clients and prospects ask us how PrecisionLender works in conjunction with CECL. There are both similarities and differences in the credit migration approach that PrecisionLender uses vs. the accounting treatment for a loan using the CECL methodology.
At its core, CECL is a methodology that accounts for potential loss at a pool or portfolio level, which may be defined as a certain asset class and may have similar characteristics related to industry or collateral, as well as the borrower’s credit rating.
On the other hand, PrecisionLender is designed to be used at the instrument level. Very low-level differentiators can be configured within the solution, such as loan to value, recovery rate by collateral type, tenor, Loss Given Default (LGD) and various guarantee types (both Govt. and Private), to discern differentiation between loan instruments. This manifests a risk adjusted return calculation (RAROC or often referred to as “ROE” within PrecisionLender) that can be used to drive the loan structuring decision.
It’s important to note that while at its core PrecisionLender can calculate all these various scenarios, the real goal of the solution is to give your bank a sales and coaching tool to win business with acceptable risk/return characteristics that fit into the borrower’s preferences.
In general, there is great leeway that banks can use to implement CECL and build the underlying assumptions, as the new standard does not specifically detail a single means to estimate the expected credit loss over the life of each instrument. There may also be different estimation techniques that vary by pool or portfolio. Some of these methods may include historical loss rates, discounted cash flow, and Probability of Default (PD) and LGD. For the CECL methodology, the intent is to build a Life of Loan expected loss rate, provision for that at inception, and if the credit performs, recover that provision into income over the life of the loan.
How are the approaches to Loan Loss Reserve Similar in PrecisionLender and CECL?
Both approaches consider a life of loan calculation with regards to credit loss that would be attributable to the income statement in the form of a provision expense. PrecisionLender uses credit migration combined with the Basel III standard to account for both annual loss (expected loss) and the application of credit capital to account for the unexpected loss.
(While allocation of credit capital is important in PrecisionLender to create a denominator for the Return on Equity or RAROC ratio, it is not applicable to this portion of the loan loss discussion.)
PrecisionLender typically takes a high-level approach to calculating the applicable levels of loan loss reserve which is then stratified by both tenor and risk rating of each specific client and lending opportunity. This is done by conducting a credit migration analysis to determine how loans may move from one risk rating to another over time, and ultimately determining the likelihood of a default. Again, this is typically done at a high-level in order to have a sufficient sample size. The outcome of this exercise represents a PD of an unsecured facility at each risk rating. For more information, see How to Determine the Capital Calculation.
PrecisionLender uses a Provision for Credit Loss (PCL) methodology to duration factor the yearly PD’s. It then uses collateral and guarantees to mitigate the unsecured portion. The bank ultimately ends up with a monthly Adjusted Exposure at Default to which the duration-based PCL ratios are then applied. This is done for pricing or reviewing each individual loan.
Typically, a CECL approach might start at a lower level, such as a multi-family commercial real estate portfolio or a more diversified group of commercial loans all with similar risk characteristics. In those cases, there might be a determination made that is based on the portfolio’s historical performance.
Previously, loans in that portfolio identified as having an impairment, would have a specific allowance for losses created. Under the new CECL approach, the review isn’t made at the loan level, but rather at the pool or portfolio levels and reserves will be adjusted based on the current situation, which may result in additional reserves (which would be a hit to income) or perhaps the reversal of reserves (leading to an increase in income).
Implications From an Accounting Perspective
It should be noted that PrecisionLender was not built to be in full compliance with GAAP when calculating the annual income of a loan. The math considerations used in PrecisionLender are intended to give an average over the life of a loan vs. recognizing short term income up front. Additionally, PrecicisionLender gives an estimate of the economic value of the loan at the inception point. For some additional break down of the math, see How Does the Math Work.
Once a loan gets booked, there can be many factors that change the current economic value of the loan, such as the overall financial health of the sponsoring entity, the value of the collateral or underlying recovery factors, and especially the interest rate environment. At inception, both the CECL method and PrecisionLender, must hold some of those influences constant and assume that they won’t change throughout the term of the loan, or the math calculations would not be possible.
PrecisionLender captures those variables and calculates economic values for the average life of the loan. Once that loan is booked, the PrecisionLender Relationship Awareness module will then update those values as the loan moves through time. Even if none of the underlying assumptions change, such as the risk rating or collateral amount, the ROE will change due to the remaining term effects of credit capital, Loan Loss reserve and the impact of carrying costs.
The CECL method would ultimately “charge-off” into a reserve a percentage of the loan amount deemed to be a default rate. That charged off amount would impact earnings in the inception period. If we assume that the underlying CECL assumptions remain the same throughout the term of the loan (no credit deterioration) then a portion of that charged off amount could be returned to income over the course of the loan and may ultimately result in a true loss of $0 (assuming actual loan loss is less than projected). Of course, when you apply this method to a portfolio of loans with different maturities, new fundings, and changing risk assumptions, the amount of the reserve and the impact to income moves as well.
As you can see, there are similarities and differences in CECL and the way that PrecisionLender accounts for credit risk. However, they are ultimately like comparing apples and oranges, as CECL is really an accounting treatment and PrecisionLender applies many aspects of risk to drive pricing differentiation across the different types of products with different collateral and terms in order to build a purposeful balance sheet.
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