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Expected credit loss ecl

What Is Expected Credit Loss (ECL)?

Expected credit loss (ECL) is a forward-looking accounting estimate of the present value of all cash shortfalls over the expected life of a financial instrument. It falls under the broader financial category of financial accounting. Unlike previous "incurred loss" models that recognized losses only after a credit event had occurred, the ECL model requires entities to anticipate and account for potential future losses, even before a borrower defaults92, 93, 94. This means that a credit loss can arise even if full payment is expected, but later than contractually due91. The amount of expected credit loss is updated at each reporting date to reflect changes in credit risk since the initial recognition of the financial asset90.

History and Origin

The concept of Expected Credit Loss (ECL) gained prominence as a direct response to the shortcomings exposed during the 2008 global financial crisis. A significant criticism of the pre-crisis accounting standards, particularly IAS 39 (International Accounting Standard 39), was their "incurred loss" model, which only allowed banks to recognize loan losses when objective evidence of impairment existed88, 89. This backward-looking approach meant that losses were often recognized too late in the economic cycle, exacerbating the crisis's impact by delaying the provisioning for anticipated defaults86, 87.

In response to a mandate from the G20, global accounting standard-setters aimed to establish a more forward-looking approach to loan loss provisioning84, 85. This led to the development and eventual issuance of International Financial Reporting Standard 9 (IFRS 9) by the International Accounting Standards Board (IASB) in July 201482, 83. IFRS 9, effective for annual periods beginning on or after January 1, 2018, introduced the Expected Credit Loss framework, fundamentally changing how financial institutions account for and provision for credit losses80, 81. Similarly, in the United States, the Financial Accounting Standards Board (FASB) issued ASU 2016-13 in June 2016, introducing the Current Expected Credit Loss (CECL) standard, which became effective for most public companies in December 201978, 79. Both IFRS 9 and CECL aim to provide more timely recognition of expected credit losses.

Key Takeaways

  • Expected Credit Loss (ECL) is a forward-looking measure that estimates potential credit losses over the lifetime of a financial instrument.
  • The ECL model, introduced by IFRS 9, replaced the previous "incurred loss" model, requiring earlier recognition of potential losses.
  • ECL calculations incorporate historical data, current conditions, and reasonable and supportable forward-looking information.
  • Financial assets are categorized into three stages based on changes in credit risk, which dictate whether 12-month or lifetime ECLs are recognized.
  • ECL aims to improve transparency and financial stability by providing a more proactive approach to credit loss provisioning.

Formula and Calculation

The calculation of Expected Credit Loss (ECL) typically involves three key components: Probability of Default (PD), Exposure at Default (EAD), and Loss Given Default (LGD).

The general formula for ECL is:

ECL=PD×EAD×LGD\text{ECL} = \text{PD} \times \text{EAD} \times \text{LGD}

Where:

  • PD (Probability of Default): This is an estimate of the likelihood that a borrower will default on their financial obligation within a specific period (e.g., 12 months or over the lifetime of the instrument). It is often determined based on historical default rates and adjusted for forward-looking economic conditions77.
  • EAD (Exposure at Default): This represents the total outstanding amount that is expected to be owed by the borrower at the time of default. For a loan, this might be the remaining principal balance plus any accrued interest. For other financial instruments, it could be the maximum potential exposure under a commitment76.
  • LGD (Loss Given Default): This is the percentage of the exposure at default that the lender expects to lose after considering any recoveries from collateral or other mitigating factors. LGD is an adjustment to the ECL calculation for post-default recoveries75.

Under IFRS 9, the calculation of ECL applies to financial assets measured at amortized cost or at fair value through other comprehensive income, such as loans, debt securities, and trade receivables74. The calculation can be for 12 months or the lifetime of the financial asset, depending on whether there has been a significant increase in credit risk since initial recognition73.

Interpreting the Expected Credit Loss

Interpreting Expected Credit Loss (ECL) involves understanding its dynamic nature and its implications for a financial institution's financial health and risk management. The ECL represents management's forward-looking expectation of potential shortfalls in contractual cash flows from financial assets72. A higher ECL indicates a greater anticipated loss from a loan or portfolio of loans, signaling increased credit risk.

Under IFRS 9, financial assets are categorized into three stages, which directly influence the ECL recognition:

  • Stage 1: 12-Month ECL. When a financial instrument is initially recognized or if its credit risk has not significantly increased since initial recognition, a loss allowance is recognized for expected credit losses resulting from default events that are possible within the next 12 months70, 71. Interest revenue is calculated on the gross carrying amount of the asset68, 69.
  • Stage 2: Lifetime ECL (Not Credit-Impaired). If there has been a significant increase in credit risk since initial recognition, but the asset is not yet credit-impaired, lifetime expected credit losses are recognized66, 67. This means the ECL is estimated over the entire expected life of the financial instrument. Interest revenue is still calculated on the gross carrying amount65. Assessing a "significant increase in credit risk" requires judgment and the use of reasonable and supportable forward-looking information64.
  • Stage 3: Lifetime ECL (Credit-Impaired). When a financial asset becomes credit-impaired (i.e., there is objective evidence of default or significant financial difficulty of the debtor), lifetime expected credit losses are recognized61, 62, 63. In this stage, interest revenue is calculated on the net carrying amount (gross carrying amount less the loss allowance)59, 60.

This staged approach means that ECL is not a static number but rather a dynamic assessment that changes with the credit quality of the underlying assets. A transition from Stage 1 to Stage 2, for example, would result in a significant increase in the recognized ECL, reflecting a deterioration in the perceived creditworthiness of the borrower. Investors and analysts use ECL disclosures to gauge a bank's exposure to credit risk and the adequacy of its provisions against future losses.

Hypothetical Example

Consider "LendCo," a hypothetical financial institution that issues a $100,000 personal loan to an individual, Sarah, for a term of five years.

Initial Recognition (Stage 1):
Upon originating the loan, LendCo assesses Sarah's credit risk. Based on her strong credit history, stable income, and the prevailing economic conditions, LendCo estimates:

  • Probability of Default (PD) over the next 12 months: 0.5%
  • Exposure at Default (EAD): $100,000
  • Loss Given Default (LGD): 30%

The 12-month Expected Credit Loss (ECL) is calculated as:

ECL=0.005×$100,000×0.30=$150\text{ECL} = 0.005 \times \$100,000 \times 0.30 = \$150

LendCo would record a loss allowance of $150 on its balance sheet.

One Year Later (Scenario 1: No Significant Increase in Credit Risk):
A year passes. Sarah has consistently made her payments on time, and there have been no material changes in her financial situation or the economic outlook. The loan remains in Stage 1. LendCo updates its assessment, perhaps revising the 12-month PD slightly due to the passage of time or minor economic shifts. The updated ECL would be recognized.

One Year Later (Scenario 2: Significant Increase in Credit Risk):
One year later, Sarah's employer announces significant layoffs, and while she is not immediately affected, the company's future looks uncertain. This represents a significant increase in Sarah's credit risk, even though she has not yet missed a payment. The loan transitions to Stage 2.

Now, LendCo must calculate the lifetime Expected Credit Loss. Based on updated models and forward-looking information, LendCo estimates:

  • Lifetime PD (over the remaining 4 years): 10%
  • Remaining EAD: $80,000 (after one year of payments)
  • LGD: 35% (slightly higher due to economic uncertainty)

The lifetime ECL is calculated as:

ECL=0.10×$80,000×0.35=$2,800\text{ECL} = 0.10 \times \$80,000 \times 0.35 = \$2,800

LendCo would increase its loss allowance from $150 to $2,800, reflecting the heightened risk. This illustrates how the ECL model proactively recognizes potential losses based on changes in financial risk before an actual default occurs.

Practical Applications

Expected Credit Loss (ECL) is primarily applied in financial institutions, particularly banks, for regulatory compliance and financial reporting. Its most significant application is under IFRS 9 (International Financial Reporting Standard 9), which mandates a forward-looking approach to recognizing credit losses on financial instruments57, 58. This impacts how banks provision for potential losses on their loan portfolios, debt securities, and other financial assets.

Beyond financial reporting, ECL models are integral to:

  • Credit Risk Management: Banks use ECL calculations to assess and monitor the creditworthiness of their borrowers and portfolios. This proactive assessment helps in making informed decisions regarding lending, pricing of loans, and setting appropriate risk limits55, 56.
  • Capital Adequacy: Regulatory bodies, such as the Basel Committee on Banking Supervision, issue guidance on how ECL affects banks' capital adequacy requirements53, 54. While ECL is an accounting concept, its impact on provisions directly influences a bank's reported profits and, consequently, its regulatory capital52.
  • Stress Testing: Financial authorities and institutions incorporate ECL models into stress tests to evaluate the resilience of banks under adverse economic scenarios. These tests simulate how credit losses might escalate during downturns, providing insights into potential vulnerabilities and capital needs50, 51.
  • Loan Origination and Pricing: The expected credit loss framework allows banks to more accurately price new loans by incorporating the anticipated lifetime losses into the interest rates and fees charged to borrowers. This ensures that the compensation for taking on credit risk is adequate.
  • Investor Relations and Transparency: ECL disclosures provide investors with a more transparent view of a bank's asset quality and exposure to credit risk48, 49. For example, recent reports have highlighted how major banks, like HSBC, have seen increases in expected credit losses due to exposures in sectors like commercial real estate, impacting their profitability46, 47. This increased transparency is intended to improve market discipline and reduce the "too little, too late" problem observed in previous accounting standards45.

The implementation of ECL models necessitates robust data, sophisticated analytical tools, and expert judgment to forecast future economic conditions and their impact on credit portfolios.

Limitations and Criticisms

While the Expected Credit Loss (ECL) model represents a significant advancement in financial accounting, aiming for timelier recognition of credit losses, it is not without its limitations and criticisms.

One primary concern is the increased complexity and judgment required in its application44. Estimating future credit losses involves forecasting economic conditions, which inherently introduces subjectivity and can be challenging, especially during periods of high economic uncertainty. The reliance on forward-looking information means that ECL provisions can be sensitive to macroeconomic assumptions, potentially leading to volatility in financial statements42, 43.

Another criticism revolves around procyclicality. While ECL aims to mitigate the "too little, too late" problem of previous incurred loss models, some argue it could contribute to procyclical behavior in lending. In an economic downturn, banks might recognize significantly higher ECLs, which would reduce their profits and regulatory capital. This, in turn, could lead them to tighten lending standards and reduce credit availability, potentially worsening the downturn40, 41. The International Monetary Fund (IMF) has acknowledged that while ECL models anticipate downturns, they may only do so shortly before their occurrence, potentially leading to a sizable increase in provisions that could have undesired procyclical effects via banks' profits and regulatory capital38, 39.

Furthermore, the comparability of financial statements across different institutions can be challenging due to the varying methodologies and assumptions used in ECL models36, 37. While regulators like the European Securities and Markets Authority (ESMA) have issued reports to improve compliance and transparency, significant room for improvement remains in the comparability of disclosures on expected credit losses35. This can make it difficult for investors and analysts to accurately compare the credit risk profiles of different banks.

There are also operational challenges related to data availability and model validation. Developing and maintaining robust ECL models requires extensive historical data on defaults, recoveries, and macroeconomic variables. Smaller institutions, in particular, may face difficulties in sourcing and processing the necessary data, as well as in validating the complex models required by the ECL framework33, 34.

Expected Credit Loss (ECL) vs. Incurred Loss

The fundamental difference between Expected Credit Loss (ECL) and the incurred loss model lies in the timing of loss recognition within financial accounting.

The incurred loss model, which was the prevailing standard under IAS 39, dictated that financial institutions could only recognize a credit loss when objective evidence of impairment had occurred31, 32. This meant that a bank would wait for a specific "loss event," such as a missed payment, a breach of loan covenants, or observable financial difficulty of the borrower, before booking a provision for that loss29, 30. The criticism of this backward-looking approach was that it often led to a delayed recognition of losses, especially during economic downturns, making financial statements less reflective of the true financial health of an institution27, 28. Losses were recognized "too little, too late"26.

In contrast, Expected Credit Loss (ECL), introduced by IFRS 9, adopts a forward-looking approach. Under the ECL model, financial institutions are required to recognize credit losses at all times, taking into account past events, current conditions, and reasonable and supportable forecasts of future economic conditions23, 24, 25. This means that a provision for expected credit losses is established from the moment a financial instrument is originated, even if there is no immediate evidence of impairment21, 22. The ECL framework anticipates potential losses over the lifetime of the financial instrument, reflecting the probability-weighted estimate of credit losses19, 20. This proactive approach aims to provide more timely and relevant information about a bank's expected credit losses to investors and other stakeholders17, 18.

FeatureExpected Credit Loss (ECL)Incurred Loss
Timing of RecognitionProactive; losses recognized based on expectation of future credit events, from initial recognition.Reactive; losses recognized only when an actual loss event has occurred and objective evidence of impairment exists.
Information UsedHistorical data, current conditions, and forward-looking macroeconomic forecasts.Primarily historical data and current observable evidence of impairment.
PrincipleAnticipates potential future losses.Accounts for losses that have already occurred.
StandardIFRS 9 (International Financial Reporting Standard 9), CECL (Current Expected Credit Loss) in US GAAP.IAS 39 (International Accounting Standard 39) prior to IFRS 9.
Impact on ProvisionsGenerally results in earlier and potentially higher provisions for credit losses, especially during economic downturns.Provisions are typically lower and delayed, as they only reflect realized losses, potentially exacerbating downturns.
GoalEnhanced transparency, earlier recognition of risks, and reduced procyclicality (though some debate remains on this point).Simpler application, but criticized for "too little, too late" recognition of losses.

FAQs

Why was the Expected Credit Loss (ECL) model introduced?

The ECL model was introduced primarily to address the shortcomings of the previous "incurred loss" accounting model, which was criticized for recognizing credit losses too late, particularly during the 2008 global financial crisis14, 15, 16. The aim of ECL is to ensure a more timely and forward-looking recognition of potential credit losses, thereby improving the transparency and stability of financial reporting12, 13.

Does ECL mean banks recognize losses before they happen?

Yes, in essence, it does. Unlike the old model that waited for an actual default or loss event, the Expected Credit Loss model requires banks to estimate and provide for potential future losses on financial assets from the moment they are originated10, 11. This is based on probabilities and forecasts, meaning a provision is made even if a loss is only expected, not yet incurred. This proactive approach aims to prevent delays in loss recognition during economic downturns.

What are the three stages of ECL under IFRS 9?

Under IFRS 9, financial instruments are categorized into three stages for Expected Credit Loss recognition:

  • Stage 1: Applies to financial instruments that have not experienced a significant increase in credit risk since initial recognition. Only 12-month expected credit losses are recognized9.
  • Stage 2: Applies when there has been a significant increase in credit risk since initial recognition, but the asset is not yet credit-impaired. Lifetime expected credit losses are recognized8.
  • Stage 3: Applies to financial assets that are credit-impaired (i.e., objective evidence of default exists). Lifetime expected credit losses are recognized6, 7.

How does the economy affect Expected Credit Loss?

The economy plays a significant role in Expected Credit Loss calculations. ECL models are forward-looking and incorporate macroeconomic factors such as GDP growth, unemployment rates, and interest rates into their estimates4, 5. During economic downturns, higher unemployment or slower GDP growth can lead to an increase in anticipated defaults, resulting in higher ECL provisions. Conversely, a strong economy might lead to lower ECL provisions, as the probability of default is generally lower. This direct link to macroeconomics is a key feature of the ECL framework.

Is Expected Credit Loss the same as impairment?

Expected Credit Loss (ECL) is not the same as impairment, but they are closely related. ECL is a measure or estimate of potential credit losses over time, even before a default occurs3. Impairment, on the other hand, refers to the accounting recognition of a loss when a financial asset's carrying amount exceeds its recoverable amount. The ECL model under IFRS 9 is essentially the framework for calculating and recognizing this impairment in a forward-looking manner, replacing the older "incurred loss" impairment model1, 2.

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