The major difference between the incurred loss method used in today’s ALLL allowance or reserve calculation and the CECL expected loss method is a change in timing.
Our familiar incurred loss methodology prevents us from creating a reserve until a tangible, specific loss event becomes probable. In the words of the standard, it then is said to be incurred.
The new and unfamiliar CECL expected loss methodology turns this relationship on its head and requires us instead to estimate the life of loan loss on day one when we originate the loan.
But at the end of the day, the actual total loss recognized by any financial institution is going to be exactly the same under CECL as under the incurred loss method.
The loss is the loss, no matter how (or when) you measure it. What differs is the timing of recognizing the loss. So how do we reconcile the very different approaches (incurred vs expected) with the fact that the final answer is the same?
It boils down to risk versus loss.
The incurred loss method, based upon specific negative credit events, measures the current loss in our loan portfolio. Measuring this current loss year after year, the incurred loss method calculates the total loss cumulatively over time. This cumulative total loss is adjusted as recoveries are received periodically.
CECL’s expected loss method, on the other hand, measures the current risk in our loan portfolio. This risk calculation, covering the entire expected life of our loan portfolio, and also adjusted for recoveries, is designed to estimate the total cumulative loss as of any given origination or reporting date.
So what are the practical implications of changing from a methodology that measures current loss to one that measures current risk?
One obvious starting spot is recognizing that at any point in time a portfolio likely has a much greater current risk than current loss. Which is why the expectation is that CECL implementation will result in a larger day one adverse shift in reserves.
In preparation for that shift towards larger reserves at CECL implementation bank regulators have enacted an election for a 3 year phase in of the adverse day one CECL impact.
But what about after the fact, after the initial CECL reserve has been established?
The major ongoing impact is likely to be shown in an enhanced preference for shorter term loans. As loan term lengthens, the day one CECL impact of a new loan grows along with the maturity. That implies a lower ROI for longer loans and even more community bank concentration in the short to intermediate maturities.
Another likely shift is a direct result of the more visible credit cost of longer term loans. A more disciplined pricing model is one foreseeable consequence of CECL. Once we estimate our CECL loan credit costs, don’t be surprised if your examiners insist you incorporate it into both your loan pricing and capital planning decisions.
Finally, expect to see more demand for calculating account by account customer profitability. Once CECL is established as the accepted credit cost of a loan throughout the institution, one of the biggest impediments to calculating customer profitability will fall by the wayside.
We’ll all be using the same numbers. Deposit gatherers and lenders will start to feel the impact of performance measurement in a whole new way. Prepare to start evaluating customer profitability, and then to start segmenting customer pricing and benefits by profit.
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