DebtX Insights: The Unexpected Benefits of CECL

Nobody enjoys talking about Current Expected Credit Loss, assigning staff to CECL project teams or building models to calculate Expected Loss.  For many lenders, CECL appears to represent yet another burden that takes time, energy and money away from the business of making loans.

This past year, the banking world was rocked by Covid, the proverbial punch in the nose that laid waste to the best made plans.  Renters stopped paying landlords.  Landlords stopped paying lenders.  And for a meaningful, nerve-wracking period of time, there did not appear to be any predictably safe landing in sight.  Despite regulatory relief and the opportunity to generate PPP loans for some fee revenue, fear amongst small and medium sized lenders was palpable, with the universally asked question being:

Just how bad can this thing get?!

However, for banks subject to DFAST and CCAR requirements, that question is generally already answered via their annual stress tests, which require consideration of the Fed Baseline, Adverse and Severely Adverse scenarios.  While no predictive scenario will necessarily capture the messiest of future details, most quants will agree the “Severe” scenario is indeed Draconian enough.  As a result of Fed stress cases (and no doubt some bespoke analysis), big banks generally led the way early during Covid with increased reserves, demonstrating precisely their answer to the above-posed question.

Interestingly, banks who were sub $10 billion but early adopters of CECL benefitted in a real way; if their forward-looking models were robust and provided for multiple stressed scenarios, they could calculate a meaningful and quantitatively based increase in reserves.  Since most loan credit characteristics are updated annually (or in some cases never), running analysis on stale data does not provide much insight into potential downsides.  To wit: the 60% loan-to-value, 2.0x debt service coverage numbers on a retail center probably were not accurate as space was going dark at an alarming rate.

With those originally unwanted, unloved CECL tools at their disposal, smaller banks could have substantial conversations with their boards and other stakeholders about potential downside and capital needs. And imagine how useful those stressed, downside estimates were in discussions with examiners?

Explore our Stress Testing Services.

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