Expected credit loss

What Is Expected Credit Loss?

Expected credit loss (ECL) is a forward-looking measure of potential financial losses that a lender or financial institution anticipates from its financial assets due to a borrower's failure to meet contractual obligations. It falls under the broader category of financial accounting and risk management, particularly relevant for financial instruments suchs as loans, debt securities, and trade receivables. Unlike previous accounting models that recognized losses only when an impairment event had occurred, ECL requires entities to recognize provisions for losses based on future expectations, even if a default event has not yet happened. This proactive approach aims to provide a more realistic assessment of a firm's credit risk exposure.

History and Origin

The concept of expected credit loss gained prominence in the aftermath of the 2008 global financial crisis. Prior to this, many accounting standards, notably IAS 39 'Financial Instruments: Recognition and Measurement,' operated on an "incurred loss" model. This model was criticized for recognizing credit losses "too little, too late," contributing to the amplification of financial instability during downturns.²⁸,²⁷ In response to calls from the G20 leaders to strengthen accounting for loan loss provisions, the International Accounting Standards Board (IASB) initiated a project to replace IAS 39.²⁶

This culminated in the issuance of International Financial Reporting Standard 9 (IFRS 9) 'Financial Instruments' in July 2014, with a mandatory effective date of January 1, 2018.²⁵,²⁴ IFRS 9 introduced the revolutionary expected credit loss (ECL) impairment model, mandating financial institutions to account for expected credit losses at all times, considering past events, current conditions, and forward-looking information.²³ This significant shift aimed to ensure more timely recognition of potential losses and enhance transparency in financial reporting.

Key Takeaways

• Expected credit loss (ECL) is a forward-looking estimate of credit losses on financial assets.
• It is a core component of IFRS 9, replacing the previous "incurred loss" model.
• ECL calculations incorporate probabilities of default, loss given default, and exposure at default over the lifetime of the financial instrument.
• Financial institutions must assess changes in credit risk and adjust ECL provisions accordingly at each reporting date.
• The model requires significant judgment and the use of macroeconomic forecasts.

Formula and Calculation

The calculation of Expected Credit Loss involves a combination of three key components:

Where:

• (\text{PD}) = Probability of Default, which is the likelihood that a borrower will default on their obligations over a specified period.
• (\text{LGD}) = Loss Given Default, representing the proportion of the exposure that a lender expects to lose if a default occurs, after accounting for any recoveries.
• (\text{EAD}) = Exposure At Default, which is the total value the lender is exposed to at the time of default.

For financial assets in different stages of credit risk, the measurement period for ECL varies. For assets where credit risk has not significantly increased since initial recognition (Stage 1), a 12-month expected credit loss is recognized. For assets with a significant increase in credit risk (Stage 2) or those that are credit-impaired (Stage 3), a lifetime expected credit loss is recognized.²²,²¹

Interpreting the Expected Credit Loss

Interpreting expected credit loss involves understanding the different stages of credit risk as defined by IFRS 9. When a financial asset is initially recognized or has a low credit risk, the ECL recognized is based on the probability of default occurring within the next 12 months (12-month ECL). This reflects the portion of lifetime expected credit losses that result from default events possible within that 12-month period.²⁰,¹⁹

However, if there has been a significant increase in credit risk since the initial recognition of a financial instrument, the entity must recognize lifetime expected credit losses. This means the ECL calculation considers all possible default events over the entire expected life of the financial instrument.¹⁸,¹⁷ For credit-impaired financial assets, lifetime ECL is also recognized, and interest revenue is calculated on the net carrying amount (gross carrying amount less credit allowance).¹⁶ This nuanced approach ensures that the provision for impairment accurately reflects the current and forecasted credit quality of the asset.

Hypothetical Example

Consider a bank that issues a new loan of $100,000 to a small business. At the time of origination, the bank assesses the Probability of Default (PD) over the next 12 months to be 0.5%, the Loss Given Default (LGD) to be 40%, and the Exposure At Default (EAD) to be the full loan amount of $100,000.

In this initial assessment (Stage 1), the 12-month Expected Credit Loss (ECL) would be:

(\text{ECL} = 0.005 \times 0.40 \times $100,000 = $200)

The bank would record a provision of $200 for this loan on its balance sheet.

Now, imagine that six months later, economic conditions worsen, and the small business sector faces significant headwinds. The bank reassesses the credit risk and determines that there has been a significant increase in credit risk for this loan, moving it to Stage 2. The estimated lifetime PD is now 3%, and LGD and EAD remain 40% and $100,000, respectively.

The Lifetime Expected Credit Loss (ECL) would be:

(\text{ECL} = 0.03 \times 0.40 \times $100,000 = $1,200)

The bank would then adjust its provision for loan loss, increasing it from $200 to $1,200 to reflect the higher anticipated losses over the loan's lifetime. This example illustrates how the expected credit loss framework mandates dynamic adjustments based on changes in credit risk.

Practical Applications

Expected credit loss is a critical concept with wide-ranging practical applications, particularly within the financial sector. Banks and other lending institutions utilize ECL models for their loan loss provisioning, which directly impacts their reported profit and loss. This provisioning also influences capital adequacy requirements, as regulatory frameworks like Basel III require banks to hold sufficient capital against potential credit losses.¹⁵,¹⁴

Beyond regulatory compliance, ECL models are integral to a financial institution's internal credit risk management. They inform decisions regarding loan pricing, underwriting standards, and portfolio management. By forecasting potential losses, institutions can better manage their overall exposure to credit risk and allocate resources more effectively. The data and methodologies used for ECL calculations also provide valuable insights for investors and analysts assessing the financial health and risk profile of an entity.¹³ For instance, the European Banking Authority (EBA) evaluates banks' ECL frameworks, particularly during periods of economic stress, to understand impacts on asset quality and cost of risk.¹² Implementing ECL effectively promotes greater transparency in financial reporting, offering stakeholders a clearer view of an entity's credit risk profile and risk management practices.¹¹,¹⁰

Limitations and Criticisms

Despite its advantages in promoting earlier recognition of credit losses, the implementation of the expected credit loss (ECL) model under IFRS 9 has faced several limitations and criticisms. One primary concern is the significant level of judgment and estimation required, particularly in forecasting future economic conditions and assessing "significant increases in credit risk." This subjectivity can lead to diversity in practice among different entities, potentially impacting the comparability of financial statements.⁹,⁸

Critics also highlight the potential for increased volatility in loan loss provisioning and, consequently, in reported earnings, especially during periods of economic uncertainty. The COVID-19 pandemic, for instance, exposed challenges in ECL models, as rapid shifts in macroeconomic indicators necessitated significant post-model adjustments (PMAs) by financial institutions.⁷ While PMAs can address model limitations, their use can also raise questions about transparency and consistency if not adequately disclosed and justified.⁶,⁵ Some respondents to the IASB's post-implementation review of IFRS 9's impairment requirements noted that despite general satisfaction, diversity in practice regarding forward-looking scenarios and PMAs reduced the usefulness of information.⁴ Furthermore, the forward-looking nature of ECL, while beneficial, can introduce procyclical effects, potentially exacerbating economic downturns if higher provisions restrict lending when it is most needed.³

Expected Credit Loss vs. Incurred Loss

The fundamental difference between expected credit loss (ECL) and incurred loss models lies in the timing and triggers for recognizing credit losses.

The incurred loss model, characteristic of IAS 39, required objective evidence of a loss event before a provision could be recognized. This meant that banks often recognized credit losses after the actual deterioration had occurred, sometimes contributing to a delayed market reaction and potentially amplifying economic cycles.²,¹ In contrast, expected credit loss, as mandated by IFRS 9, requires entities to continuously assess and provision for potential future credit losses from the moment a financial instrument is originated. This shift emphasizes a more proactive and predictive approach to impairment, aiming to provide a more timely and accurate reflection of credit risk.

FAQs

What is the primary objective of Expected Credit Loss (ECL)?

The primary objective of ECL is to provide a more timely and forward-looking recognition of credit losses on financial assets, enhancing the relevance and transparency of financial statements. It requires entities to account for potential losses even before an actual default event occurs.

How does Expected Credit Loss (ECL) differ from past due amounts?

Past due amounts refer to payments that a borrower has failed to make by their contractual due date. While past due status is an indicator of increased credit risk and can trigger a higher ECL provision (moving from 12-month to lifetime ECL), ECL itself is an estimate of future losses, not merely a reflection of current overdue payments.

Is Expected Credit Loss (ECL) only applicable to banks?

While banks and other financial institutions are most significantly impacted due to their extensive portfolios of financial instruments, the ECL model under IFRS 9 applies to a wide range of entities holding financial assets such as trade receivables, lease receivables, and loan commitments.

What are the three stages of Expected Credit Loss (ECL)?

IFRS 9 categorizes financial assets into three stages for ECL measurement:

1. Stage 1: Financial instruments that have not experienced a significant increase in credit risk since initial recognition. A 12-month expected credit loss is recognized.
2. Stage 2: Financial instruments that have experienced a significant increase in credit risk since initial recognition but are not yet credit-impaired. A lifetime expected credit loss is recognized.
3. Stage 3: Financial instruments that are credit-impaired. A lifetime expected credit loss is also recognized, with a change in how interest revenue is calculated.

How does Expected Credit Loss (ECL) affect a company's profitability?

The ECL model can increase the volatility of a company's reported profit and loss because provisions for expected losses are recognized earlier and can fluctuate significantly with changes in economic forecasts and credit risk assessments. Higher ECL provisions reduce reported profits, reflecting a more cautious view of future performance.