Forecasting lifetime credit losses: Modelling considerations for complying with the new FASB and IASB current expected credit loss models
Abstract
The 2008 financial crisis revealed a critical flaw in the incurred credit loss model. Banks had to wait for losses to incur before increasing loss provisions. As a result, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) have both proposed their own versions of a ‘current expected credit loss’ (CECL) model to replace their incurred loss model. The CECL estimate would reflect bank managers’ current estimate of the contractual cash flows that the bank does not expect to collect, based on their assessment of credit risk as of the reporting date. The CECL model is expected to bring increased financial stability along with other benefits. However, the new model poses major implementation challenges, specifically the need to forecast lifetime expected credit losses. This article provides bank managers with the knowledge they need to navigate the most common industry modelling options available to them for addressing these challenges. To do this the authors provide insight into how common credit loss models compare in terms of strengths, limitations and considerations for improving lifetime loss forecasting accuracy.
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Author's Biography
Joseph Mcphail is a financial risk consultant at Ernst & Young (EY). Joseph specialises in quantitative modelling techniques for underwriting and financial risk management. Since 2011, he has focused on assisting banks with model development and model risk management challenges in the areas of loan loss reserving (allowance for loan and lease losses — ALLL), capital adequacy (Basel), stress testing [comprehensive capital analysis and review (CCAR)/Dodd–Frank Act stress testing (DFAST)], underwriting and pricing. Prior to becoming a consultant, Joseph worked in the finance industry as a model developer and regulator policy analyst.
Lihong Mcphail is a financial economist at the Office of Regulatory Policy at the Farm Credit Administration (FCA). She develops analytical tools on forward-looking assessment of credit risks, market risks and liquidity risks facing the financial institutions that the FCA regulates. Prior to joining the FCA, Lihong developed forecasting models and researched market impacts of derivative trading and policies at the Economic Research Service in Washington DC. Lihong obtained her PhD in Economics from Iowa State University and holds the Charted Financial Analyst (CFA) designation.
Citation
Mcphail, Joseph and Mcphail, Lihong (2014, September 1). Forecasting lifetime credit losses: Modelling considerations for complying with the new FASB and IASB current expected credit loss models. In the Journal of Risk Management in Financial Institutions, Volume 7, Issue 4. https://doi.org/10.69554/VNCS9198.
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