The strategic implications of CECL

July 15, 2019CECL—current expected credit loss–is the new accounting standard that will soon replace longstanding incurred loss-based reserve calculation at US banks. Taking effect December 15 of this year, it is one of the most significant changes to accounting standards for banks in years. It will require institutions to make changes across credit risk modeling, risk tolerance, capital levels, and even their business strategies and portfolio mix.

The experience of European banks that implemented IFRS 9, a similar standard, suggests how significant the impact will be. A report by the European Banking Authority showed that overall loan loss provisions rose by an average of 9 percent for 53 sampled banks, and Common Equity Tier 1 ratios declined by an average of 51 basis points.

By many accounts, the impact of CECL in the US will be even more severe than IFRS 9 was for European banks; US banks that have released preliminary estimates expect increases in total reserves of up to 35 percent from 2018. These banks report varied impacts by portfolio, with credit cards typically leading to the greatest share of increase, followed by home lending, auto, and wholesale.

As US banks refine their understanding of CECL’s impact and react, the remaining months of this year offer a final opportunity to make important decisions. We believe they will need to answer critical questions in three areas: 1. Determining CECL’s strategic implications and making related business decisions; 2. Integrating CECL into financial reporting and stress testing; and 3. Refining their modeling approaches.

Banks that address these questions will be able to right-size their portfolio mix, adapt their underwriting and credit risk management practices, and recalibrate pricing. They will minimize CECL’s adverse impacts, and position themselves to capture market share.

Determining the strategic implications and making business decisions

Given the significant impacts to banks’ businesses that CECL will bring, senior leaders must answer these strategic questions:

1. What is the overall expected impact from CECL on our reserves and income (especially considering the pro-cyclicality of CECL)?
2. What changes do we expect in the profitability of each of our key products, geographies, and customer segments?
3. For products and segments that become less attractive, what ability do we have to change pricing and product terms (e.g., duration, collateral and guarantee requirements)?
4. Are there portfolio segments we should exit as CECL will prevent us from being able to meet our profitability targets?

CECL will make some products and business lines less profitable, depending on the industry sector, the duration of a transaction, the guarantees supporting it, and the counterparty’s ratings. Therefore, banks will need to review their portfolio strategy at a much more detailed level than they do today.

For instance, they may need to reevaluate their overall business mix and strategic growth plans, restructuring or scaling down certain businesses where reserve requirements will significantly increase in the near-term.

Banks should also reevaluate their pricing methodology, in particular for longer-term and less-collateralized products, and for higher-risk clients.

Integrating CECL into financial reporting and stress testing

CECL will have an impact on several critical processes including Business-as-usual financial reporting and stress testing. To understand that impact and address it, banks should answer these questions:

1. What will be the impact of CECL during an economic downturn (including during CCAR), and are current processes tailored to handle this impact?
2. How will the current methodologies outside of models (e.g., management qualitative adjustment factors on incurred loss-based reserve calculation) be modified under the CECL regime?
3. What infrastructure needs to be improved to enable a quarterly or more frequent run (e.g., data needed for CECL model production run is not captured in an automated way today)?
4. How will the CECL requirements (e.g., multiple forward-looking scenario runs at every quarter) be integrated in the existing CCAR framework?

Today, banks are transitioning to the CECL regime under a relatively benign macroeconomic scenario. Beyond studying this scenario, it is important for them to review the impact and the effectiveness of the framework under an adverse macroeconomic scenario.

CECL reserve projections depend on many components (e.g., forecasting approach, scenarios chosen, approach during mean reversion period, long-term average losses). Each of these components require various data elements as input (e.g., scenario generation models need a constant feed of directly observable macroeconomic scenarios). Therefore, banks will need to thoroughly assess incremental data requirements and build in data and technology capabilities over the next few months.

Changing modeling approaches

To fully understand how CECL will affect modeling, banks should pressure test their modeling methodologies and assumptions. Specifically, senior leaders must answer two questions:

1. Which modeling methodology decisions and assumptions are the biggest drivers of losses?
2. What ability do we have to refine our methodologies and assumptions to better align them with business expectations and potentially moderate CECL’s impact?

Banks face a range of modeling decisions that will have a material impact on their reserves. Specifically, they should carefully consider three elements of modeling:

1. Banks are making a number of assumptions related to their model methodologies in the build-out of CECL, such as how to calculate exposure-at-default and how to select losses given default when data isn’t available. It is critical to carefully consider whether those assumptions are appropriate and reflect business reality.
2. Banks should carefully consider the assumptions around the length of the “reasonable and supportable” forecasting period. Under CECL in business as usual, banks are expected to forecast expected losses over this period. Banks should select a length of time that balances between tailoring to product characteristics and operational feasibility.
3. Banks should also carefully consider the number of economic scenarios they use, and the probability associated with them. Because CECL takes a forward-looking view, banks must forecast expected credit losses under various scenarios during the reasonable and supportable period. For example, giving higher probability to an adverse scenario will mean higher CECL reserves.

As with IFRS 9, most banks should expect that CECL will increase overall reserve levels. It will also have a disparate impact on certain portfolios and products. These impacts warrant significant strategic changes for banks, including potentially exiting or scaling down certain businesses. Banks that respond quickly will be rewarded with outperformance for years to come.