Guidance on accounting for expected credit losses
Feb 16, 2015
For a whitepaper on this topic, access Transitioning to an Expected Loss Model
In February 2015, the Basel Committee on Banking Supervision released a consultative document highlighting the expectations associated with the transition to accounting for expected credit losses. The objective of the document is to “set out supervisory requirements on sound credit risk practices associated with the implementation and ongoing applications of expected credit loss (ECL) accounting models.”
Because the Basel Committee operates independently of the FASB, IASB and other accounting standard setters, this document serves as a type of universal overview of what is needed to transition from an incurred loss model to one of expected loss. As the committee put it, “the paper is intended to set forth supervisory requirements for ECL accounting that do not contradict the applicable accounting standards established by the IASB or other standard setters…the requirements described are equally applicable under all accounting frameworks.”
So what does that mean then for banks in the United States anticipating the FASB’s release of its “IFRS 9 relative,” the Current Expected Credit Loss (CECL) model? Well, while we still don’t know exactly what an expected loss calculation will entail, we have better insight into what will be required to make the transition to the new model.
The Committee highlights eleven principles for sound credit risk practices that interact with expected credit loss measurement:
Principle 1: A bank’s board of directors (or equivalent) and senior management are responsible for ensuring that the bank has appropriate credit risk practices, including effective internal controls, commensurate with the size, nature and complexity of its lending exposures to consistently determine allowances in accordance with the bank’s stated policies and procedures, the applicable accounting framework and relevant supervisory guidance.
Principle 2: A bank should adopt, document and adhere to sound methodologies that address policies, procedures and controls for assessing and measuring the level of credit risk on all lending exposures. The robust and timely measurement of allowances should build upon those methodologies.
Principle 3: A bank should have a process in place to appropriately group lending exposures on the basis of shared credit risk characteristics.
Principle 4: A bank’s aggregate amount of allowances, regardless of whether allowance components are determined on a collective or an individual basis, should be adequate as defined by the Basel Core Principles, which is an amount understood to be consistent with the objectives of the relevant accounting requirements.
Principle 5: A bank should have policies and procedures in place to appropriately validate its internal credit risk assessment models.
Principle 6: A bank’s use of experienced credit judgment, especially in the robust consideration of forward-looking information that is reasonably available and macroeconomic factors, is essential to the assessment and measurement of expected credit losses.
Principle 7: A bank should have a sound credit risk assessment and measurement process that provides it with a strong basis for common systems, tools and data to assess and price credit risk, and account for expected credit losses.
Principle 8: A bank’s public reporting should promote transparency and comparability by providing timely, relevant and decision-useful information.
Principle 9: Banking supervisors should periodically evaluate the effectiveness of a bank’s credit risk practices.
Principle 10: Banking supervisors should be satisfied that the methods employed by a bank to determine allowances produce a robust measurement of expected credit losses under the applicable accounting framework.
Principle 11: Banking supervisors should consider a bank’s credit risk practices when assessing a bank’s capital adequacy
These principles serve as overarching guidelines under which banks should operate, but lack specificity and context as written. Not to fear, the document dissects these eleven principles in detail, spanning just under forty pages. For convenience’s sake, here are a few high-level takeaways that may differ from what is currently required under an incurred loss model:
- Loss estimates will be forward-looking (“In addition to historical information and current conditions, forward-looking information and macroeconomic factors are also critical when estimating future cash shortfalls, for a group of exposures or an individual exposure. Methodologies for the determination of the cash flow shortfalls may start with simple averages of a bank’s net loss experience on loans with shared credit risk characteristics over a relevant credit cycle, progressing to more complex techniques, such as migration analysis or models that estimate ECL. All methodologies should require appropriate adjustments to historical loss estimates for changes in factors that affect repayment, in particular due to forward-looking information and macroeconomic factors.”)
- You may be required to demonstrate you’ve conducted a scenario analysis (“A bank should demonstrate and document how ECL estimates would fluctuate with changes in scenarios, including changes to forward-looking information and macroeconomic factors…”)
- You may be required to perform backtesting (“Backtesting should be performed to ensure that appropriate factors are considered and incorporated, in light of historical experience.”)
- Risk ratings may take into effect forward-looking information and macroeconomic factors (“With regard to rating systems, the procedures should clearly specify the key factors, including forward-looking information and macroeconomic factors, that form the basis for assigning credit risk ratings and thus help support the monitoring, assessment and reporting of ECL for all lending exposures across the entire credit risk rating system.”)
- You may need system developments and upgrades to account for the new model (“While ECL accounting frameworks are new and different from current accounting frameworks and their implementation will require an investment in both resources and system developments/upgrades…”)
- You may need to have your model validated upon transitioning to an expected loss model, and then annually thereafter (“As the use of models involves extensive judgment, effective model validation policies and procedures are crucial. A bank should have robust policies and procedures in place to validate the accuracy and consistency of its model-based rating systems and processes and the estimation of all relevant risk components, at the outset of model usage and on an ongoing basis. Model validation should be conducted when the credit risk assessment models are initially developed and when significant changes are made to the models. A bank should regularly (at least annually) validate its models.”)
- You may need to seek information on how transitioning to an expected credit loss model impacts capital adequacy (Additionally, banks are increasingly considering a wide range of information, including that of a forward-looking nature, for risk management and capital adequacy purposes. The Committee expects banks to avail themselves of such information and the processes followed to obtain it…”)
- You should not cut corners on developing your expected loss methodology (“in the Committee’s view, consideration of forward-looking information and macroeconomic factors is essential to the proper implementation of an ECL accounting model, and therefore these costs should not be avoided on the basis that a bank considers them to be excessive or unnecessary.”)
- You may be permitted to use a range for your ALLL (“In estimating ECL, banks may determine either a single amount or a range of possible amounts. In the latter case, the Committee expects that banks will exercise prudence, defined as exercising appropriate care and caution when determining the level of ECL and the allowances to be recognised for accounting purposes to ensure that the resulting estimate is appropriate.”)
- You may have to incorporate your process for accounting for expected losses into your disclosure reports (“The Committee expects quantitative and qualitative disclosures, taken together, to provide a clear picture to users of the main assumptions used to develop ECL estimates, and the sensitivity of ECL estimates to changes in those assumptions. Additionally, the Committee expects disclosures to highlight policies and definitions that are integral to the estimation of ECL (such as a bank’s basis for grouping lending exposures into portfolios with similar credit risk characteristics and its definition of default, which the Committee expects to be guided by the definition used for regulatory purposes), factors that influence changes in ECL estimates, and how the process incorporates management`s experienced credit judgment.”)