Last month, the European Central Bank published the results of its monumental TRIM project – a detailed five-year exercise to assess the internal models used by large banks to determine risk weights and regulatory capital charges.
During the 2008/09 global financial crisis, loan-loss accounting methods were unable to provide timely, accurate information to investors about the quality of loans held by banks. CECL and IFRS 9 were introduced to address these concerns but, for different reasons, have failed to transmit useful signals in the COVID-19 economy.
The industry is currently a hive of CECL-related activity. Many banks are busily testing their systems or finalizing their preparations for the go-live date, which is either in January 2020 or somewhat later, depending on the organization. Some are still making plans for implementation, and the rest are worried that they should be.
Smaller lending institutions face a dilemma. The primary motivation behind the Current Expected Credit Loss (CECL) standard is to provide investors with enhanced forward-looking information about the state of the lending book. Producing high-quality/ low-volatility forward estimates, however, is difficult and can be expensive.
Suppose I have two competing forecasting methods, each designed for CECL or IRFS 9 loss provisioning. Both would pass muster with regulators and auditors. How do I decide which is better?
IFRS 9 and CECL were designed with two outcomes in mind: to ensure sufficient reserves on the eve of a recession and to prevent restricted lending from curtailing a nascent recovery.