A Holistic Model Validation Framework for Current Expected Credit Loss (CECL) Model Development and Implementation

Michael Jacobs

doi:10.3390/ijfs8020027

Abstract

The Current Expected Credit Loss (CECL) revised accounting standard for credit loss provisioning is the most important change to United States (US) accounting standards in recent history. In this study, we survey and assess practices in the validation of models that support CECL, across dimensions of both model development and model implementation. On the development side, this entails the usual SR 11-7 aspects of model validation; however, highlighted in the CECL context is the impact of several key modeling assumptions upon loan loss provisions. We also consider the validation of CECL model implementation or execution elements, which assumes heightened focus in CECL given the financial reporting implications. As an example of CECL model development validation, we investigate a modeling framework that we believe to be very close to that being contemplated by institutions, which projects loan losses using time-series econometric models, for an aggregated “average” bank using Federal Deposit Insurance Corporation (FDIC) Call Report data. In this example, we assess the accuracy of 14 alternative CECL modeling approaches, and we further quantify the level of model risk using the principle of relative entropy. Apart from the illustration of several model validation issues and practices that are of particular relevance to CECL, the empirical analysis has some potentially profound policy and model risk management implications. Specifically, implementation of the CECL standard may lead to under-prediction of credit losses; furthermore, coupled with the assumption that we are at an end to the favorable phase of the credit cycle, this may be interpreted as evidence that the goal of mitigating the procyclicality in the provisioning process that motivated CECL may fail to materialize.

Highlights

Introduction and DiscussionIn the United States (US), the Financial Accounting Standards Board (FASB) issues of the Generally Accepted Accounting Principles (US GAAP) are financial accounting standards intended to ensure the provision of useful information for corporate stakeholders
We presented a holistic model validation framework for Current Expected Credit Loss (CECL) model development and model implementation execution, and we illustrated elements of CECL model development validation, including the quantification of model risk
In our example of the latter validation of CECL model development, we analyzed the impact of model specification and scenario dynamics upon expected credit loss estimates in CECL, through implementing a highly stylized framework borrowed from the stress testing (ST) modeling practice

Summary

Introduction and Discussion

In the United States (US), the Financial Accounting Standards Board (FASB) issues of the Generally Accepted Accounting Principles (US GAAP) are financial accounting standards intended to ensure the provision of useful information for corporate stakeholders. The practice adequately understands the modeling aspects that appear in both the CECL and the incurred loss settings Such constructs include loan or obligor features that are inputs to credit risk parameter models, such as company financial information or exposure structure details, as well as segmentations by industry or geography, or qualitative characteristics defining management or the business environment. We present an example of CECL model validation, in which we analyze the impact of model specification and scenario dynamics upon expected credit loss estimates in CECL, through implementing a stylized framework borrowed from the ST modeling practice In this exercise, we perform a model selection of 14 alternative CECL specifications in a top-down framework, using Call Report data to construct an aggregate or average hypothetical bank, with the target variable being the NCOR and the explanatory variables constituted by Fed-provided macroeconomic variables, as well as bank-specific controls for idiosyncratic risk.

Review of the Literature

Model Validation of CECL Model Development and Implementation

Example of a CECL Modeling Framework

Example of CECL Model Development Validation

Findings

Conclusions and Future Directions