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Be Ready for the CECL Standard with Dual Risk Ratings

Now that large publicly listed banks in the US are following the latest credit loss reserve reporting rules, more lenders are preparing for the Current Expected Credit Loss (CECL) accounting standard implementation before effective dates in 2023.  

With dual risk rating methods, these institutions can be prepared for the CECL standard and calculate loan loss estimates on a loan level, which is more granular than the traditional rating approaches. 

What is CECL? 

The CECL accounting standard is to estimate credit loss reserves at the time of origination. A statement by four regulatory agencies in May 2020 showed that the CECL standard applies to all banks, savings associations, credit unions, and financial institution holding companies that file regulatory reports.  

Large publicly listed banks in the US already adopted the CECL standard. Examples include Wells Fargo, Bank of America and U.S. Bancorp. Some banks started disclosing the capital adequacy measures given the full implementation of the CECL method. 

The shift implies that for lenders anticipating loan losses at origination becomes necessary, not only for the internal risk rating purposes but also to inform investors and other stakeholders on capital structures, accordingly. 

Issued by the Financial Accounting Standards Board (FASB) in June 2016, the CECL standard aims to offer the information users a view of the lifetime expected credit loss. 

According to the FASB, the loan loss rate per the CECL guideline is based on statistical analyses. It requires organizations to measure all expected credit losses for financial instruments held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts.  

What is the dual risk rating? 

The dual risk rating is an internal credit risk rating method that risk professionals use to assess a borrower’s capacity to repay loan obligations and measures the magnitude of loss should the borrower default.  

Traditional single risk rating methods that combine borrower quality with collateral securing the loan masks the true repayment ability of the borrower leading banks to have similarly rated loans that have widely varying degrees of risk. Bifurcating the borrower risk characteristics with the collateral quality and value provides transparency to the true default risks of the borrower and the mitigation of those risks provided by collateral.  

Borrower risk ratings can then be translated along with the probability of default (PD) curve. This combined with collateral or loss given default (LGD) rating, can be used in combination with a calculated exposure at default to arrive at a dollar level expected loss calculation.  

To calculate reserves under the CECL methodology, banks without a loan level dual risk rating methodology in place must rely on top-down, portfolio level PD and LGD calculations that assume some level of homogenous risk characteristics within each portfolio. The outcome is a less precise calculation or one that applies similar PD and LGD’s to loans likely to have a widely varying degree of risk. 

The dual rating method can ensure that bank loans are originated under the reliable risk rating framework. Therefore, the use of the dual risk rating method can serve lenders as a starting point for the implementation of the CECL accounting practice. 

In addition, two subject-matter experts on CECL and credit analytics at Moody’s, a rating agency, suggested that institutions should be aware that increased risk rating scrutiny will occur to ensure that the lifetime loss estimate of different loans at origination is reflected by the risk rating used to evaluate these credits. 

The inability to provide consistent risk measurement across both systems may raise red flags during ongoing supervisory examinations over time, they added. 

The regulatory emphasis on lenders’ financial measures and their reporting is likely to support sophisticated risk rating methods as more banks are recording current credit loss estimates at the time of loan origination.