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October 22, 2018

Validation of CECL models

Introduction

 

Current expected credit loss (CECL) is a new accounting standard issued by the Financial Accounting Standards Board (FASB) for the recognition and measurement of losses expected to take place over the life of a loan. CECL will be applicable to all US banks, saving institutions, credit unions, and holding companies. It covers credit losses for loans, held-to-maturity (HTM) bonds, available for sale (AFS) bonds, lease, guarantees, trade receivables, and debt securities. Although early adoption is scheduled from 2019, entities registered with the US Securities and Exchange Commission (SEC) must implement it by 2020, while non-registered institutions have a two-year window.

 

Under the new accounting standard, the CECL model has to recognize the expected loss right at the origination of the assets (loans or investments), estimate the expected loss over the life of loan (also called the entire contractual term), and consider all past and current conditions and reasonable and supportable forecasts. Further, there is no specific methodology prescribed for developing the CECL models

 

The current expected credit loss is calculated by multiplying the PD, LGD, and EAD values and then discounting it by an effective rate of interest over time in order to get the present value of expected loss.

 

Most of the US-based banks have leveraged their existing Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act Stress Test (DFAST) models to develop CECL models, while a few are trying to develop more robust CECL-compliant models from scratch. As the CECL implementation dates near, validation of all CECL models become a key concern for financial institutions.