COVID-19 and CECL: What Are The Impacts on Model Validations?

Fourteen mid-sized US banks took a combined $17.9 billion of credit loss provisions out of their first quarter earnings, nearly three times the amount taken in Q4 2019, after the coronavirus crisis took a staggering toll on their corporate and retail borrowers. For many market practitioners, this is the first real test of their new CECL models in a severe stress scenario.

Importantly, congress has recognized the challenges and included some relief in the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which was signed into law by the President on March 27, 2020. This gives insured depository institutions, bank holding companies, and affiliates an option to delay implementation of CECL until the earlier of December 31, 2020 or the date on which the national emergency concerning COVID-19 terminates.

Supervisory agencies have also recognized the challenges posed by CECL in this environment. On March 27, 2020, the Office of the Comptroller of the Currency (OCC), Federal Reserve and Federal Deposit Insurance Corporation (FDIC) released a joint regulatory capital rule providing (in addition to the previously-announced capital phase in option for CECL) a new option for phasing in the impacts of CECL into regulatory capital over the next five years, including a full offset for two years of an estimate of the impact of CECL versus the incurred loss approach.

From a model validation perspective, the current stress environment highlights the need to have a well-defined and on-going governance process around some key components of any CECL model, for example the forward looking scenarios, the probability weights associated with them and the length of the reasonable and supportable forecast horizon. The best practice is to augment any historical data including that from past stress environments with expert judgement in a well-governed, auditable process to ensure the information is used throughout the bank in its risk management practice.