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.