Expected Credit Loss Model
The expected credit loss (ECL) model is a forward-looking accounting methodology used to estimate and recognize potential credit losses on financial assets, contrasting with the previous "incurred loss" approach. This model falls under the broader category of Financial Accounting and plays a crucial role in assessing the health of a financial institution's Balance Sheet and the overall Credit Risk within its asset portfolio. Its core principle is to account for potential losses on loans and other financial instruments before an actual Default occurs, incorporating reasonable and supportable forward-looking information. The expected credit loss model requires entities to continually evaluate their financial assets for changes in credit risk since initial recognition, leading to more timely and comprehensive recognition of potential losses.
History and Origin
The development of the expected credit loss model was a direct response to criticisms that the previous "incurred loss" models led to a "too little, too late" recognition of credit losses, particularly evident during the 2008 global financial crisis. Global accounting standard-setters, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB), embarked on projects to address this shortcoming.
The IASB introduced the expected credit loss approach as part of IFRS 9 Financial Instruments, which became mandatorily effective for annual periods beginning on or after January 1, 2018. This marked a significant shift from the IAS 39 incurred loss model, requiring entities to recognize expected credit losses at all times, based on past events, current conditions, and forecast information6.
Similarly, in the United States, the FASB issued Accounting Standards Update (ASU) No. 2016-13, Financial Instruments—Credit Losses (Topic 326), which introduced the Current Expected Credit Loss (CECL) methodology. This standard replaced the incurred loss model in U.S. Generally Accepted Accounting Principles (GAAP), requiring organizations to measure all expected credit losses for financial instruments held at the reporting date, 5and became effective for public business entities for fiscal years beginning after December 15, 2019, and for non-public business entities after December 15, 2021. 4The aim of both IFRS 9 and ASC 326 was to improve financial stability by enhancing transparency and promoting more proactive risk management.
Key Takeaways
- The expected credit loss model is a forward-looking accounting standard for recognizing credit losses.
- It replaced the "incurred loss" model, which was criticized for delayed recognition of losses.
- The model requires the consideration of past events, current conditions, and future economic forecasts to estimate potential losses.
- Key components include Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD).
- Implementation can increase the volatility of Provision for Credit Losses and impact capital ratios.
Formula and Calculation
The expected credit loss (ECL) is generally calculated as the product of three key components: Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD).
The formula can be expressed as:
Where:
- PD (Probability of Default): The likelihood that a borrower will Default on their obligations over a specified time horizon. This can be estimated using historical data, current market conditions, and forward-looking macroeconomic factors.
- LGD (Loss Given Default): The percentage of the exposure that is not expected to be recovered in the event of a default. This considers the value of any Collateral and recovery costs.
- EAD (Exposure at Default): The expected amount of exposure to a borrower at the time of Default. This includes the outstanding principal, accrued interest, and potential future drawdowns on committed facilities.
For financial assets, the calculation of expected credit losses often involves segmenting portfolios into groups with similar Credit Risk characteristics to apply these factors more efficiently.
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Interpreting the Expected Credit Loss Model
Interpreting the expected credit loss model involves understanding that it represents an entity's best estimate of future credit losses based on all available information, including qualitative and quantitative factors. Unlike its predecessor, the incurred loss model, ECL considers losses that are expected to occur over the lifetime of a financial instrument, not just those where an actual loss event has already occurred. This forward-looking perspective aims to provide a more accurate and timely reflection of an entity's financial health.
A higher expected credit loss implies a greater anticipated risk of non-payment from borrowers, which can lead to higher Loan Loss Provisions on the Income Statement. Conversely, a lower ECL suggests a more robust portfolio with less anticipated credit deterioration. Financial professionals interpret these figures to assess the quality of a bank's lending practices, the effectiveness of its risk management, and its resilience to adverse economic conditions. The model's emphasis on forward-looking information means that changes in economic forecasts can significantly impact reported ECLs, making it a dynamic and sensitive indicator of credit risk exposure.
Hypothetical Example
Consider "LendingCo," a financial institution with a portfolio of small business loans. One loan, with an outstanding balance of $100,000, was granted three years ago to "GrowthNow Inc." GrowthNow Inc. has a solid repayment history, but recent industry reports indicate a significant slowdown in their sector due to rising interest rates and supply chain disruptions.
Under an expected credit loss model, LendingCo's risk team assesses the following:
- Probability of Default (PD): Based on industry trends, GrowthNow Inc.'s current financial health, and forward-looking economic forecasts, the estimated PD for the next 12 months is 2%, and for the remaining lifetime of the loan, it's 5%.
- Loss Given Default (LGD): Should GrowthNow Inc. default, LendingCo estimates it would recover 40% of the loan value after considering any Collateral and recovery costs. Therefore, the LGD is 60% (100% - 40%).
- Exposure at Default (EAD): The outstanding balance of the loan, $100,000.
LendingCo would calculate its lifetime expected credit loss for this loan:
ECL = $100,000 (EAD) * 5% (Lifetime PD) * 60% (LGD) = $3,000
Even though GrowthNow Inc. is currently performing, LendingCo must recognize a Provision for Credit Losses of $3,000 on its Financial Statements to reflect the expected loss over the loan's lifetime, rather than waiting for an actual missed payment or other default event.
Practical Applications
The expected credit loss (ECL) model has broad practical applications across the financial sector, significantly influencing how institutions manage risk and report their financial health. Primarily, it is central to Financial Reporting for banks and other lenders, dictating the allowance for credit losses on various Financial Assets, including loans, bonds, and trade receivables. This model ensures that potential losses are recognized earlier, providing a more prudent view of asset quality.
Beyond regulatory compliance, the expected credit loss model also informs internal Risk Management practices. Financial institutions use ECL outputs to gauge their overall Credit Risk exposure, set appropriate pricing for new loans, and make strategic decisions regarding portfolio composition. It allows for a more dynamic assessment of creditworthiness, factoring in macroeconomic forecasts and industry-specific outlooks. Furthermore, the model's emphasis on forward-looking data can aid in capital planning and stress testing, helping institutions prepare for potential economic downturns. For instance, the Federal Reserve Board provides extensive guidance and FAQs on the implementation of the CECL model in the U.S., highlighting its significance for supervisory purposes.
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Limitations and Criticisms
While the expected credit loss model aims to provide a more timely and accurate reflection of credit risk, it is not without its limitations and criticisms. One significant challenge is the inherent subjectivity and complexity involved in estimating future economic conditions and their impact on default probabilities and recovery rates. This can lead to considerable judgment in applying the model, potentially resulting in varied Provision for Credit Losses across institutions and even within the same institution over time.
Another concern is the potential for increased volatility in reported earnings. Because the model requires recognizing expected losses based on forward-looking information, changes in economic forecasts—even minor ones—can lead to significant adjustments in the allowance for credit losses, which directly impacts the Income Statement. This can make Financial Statements more difficult to compare year-over-year and may complicate capital planning. Furthermore, the extensive data requirements and sophisticated modeling techniques needed for accurate ECL calculations can be particularly challenging and costly for smaller institutions, potentially creating a disparity in implementation quality. The transition to the expected credit loss model often requires significant investment in data infrastructure, analytical tools, and expert personnel, posing a hurdle for many entities.
1Expected Credit Loss Model vs. Incurred Loss Model
The fundamental difference between the expected credit loss (ECL) model and the incurred loss model lies in the timing and triggers for recognizing credit losses.
| Feature | Expected Credit Loss (ECL) Model | Incurred Loss Model |
|---|---|---|
| Timing of Loss Recognition | Proactive; losses are recognized before a default occurs, based on future expectations. | Reactive; losses are recognized only after a loss event has occurred. |
| Information Basis | Past events, current conditions, and reasonable and supportable forward-looking forecasts. | Primarily historical data and current conditions, requiring objective evidence of loss. |
| Concept of Loss | Focuses on expected future cash shortfalls over the lifetime of the financial instrument. | Focuses on actual losses that have already been incurred but not yet recognized. |
| Impact on Financials | Can lead to earlier and potentially more volatile Provision for Credit Losses. | Delays loss recognition, potentially leading to "too little, too late" provisions. |
| Regulatory Drivers | IFRS 9 (International) and ASC 326 (US CECL) | IAS 39 (International, superseded by IFRS 9) and previous US GAAP. |
The Incurred Loss Model relied on a "trigger event" (e.g., a missed payment or bankruptcy filing) before a loss could be recognized. This backward-looking approach meant that significant credit deterioration might not be reflected in Financial Statements until well after the underlying issues arose. In contrast, the expected credit loss model mandates a forward-looking assessment of credit risk, requiring entities to estimate losses over the entire contractual life of a Financial Instrument, even if no specific loss event has yet occurred. This aims to provide a more timely and comprehensive reflection of credit risk exposure.
FAQs
What is the primary objective of the expected credit loss model?
The primary objective of the expected credit loss model is to ensure that financial institutions recognize potential Credit Losses in a more timely manner by considering forward-looking information, rather than waiting for an actual loss event to occur. This helps provide a more accurate picture of an entity's financial health and exposure to Credit Risk.
How does the expected credit loss model differ from the previous incurred loss model?
The key difference is the timing of loss recognition. The expected credit loss model is forward-looking, requiring entities to estimate and account for losses over the lifetime of a Financial Asset based on expected future events. The previous incurred loss model was backward-looking, only recognizing losses once they had already occurred and there was objective evidence of impairment.
Which accounting standards require the use of the expected credit loss model?
Internationally, the expected credit loss model is mandated by IFRS 9 Financial Instruments. In the United States, a similar forward-looking approach known as Current Expected Credit Loss (CECL) is required by ASC 326, issued by the FASB.
What are the main components used to calculate expected credit losses?
The three main components for calculating expected credit losses are: Probability of Default (PD), which is the likelihood of a borrower defaulting; Loss Given Default (LGD), which is the percentage of the exposure expected to be lost in case of default; and Exposure at Default (EAD), which is the amount of exposure at the time of default.
Does the expected credit loss model make financial statements more volatile?
Yes, the expected credit loss model can introduce more volatility into Financial Statements. Because it requires the continuous reassessment of future economic conditions and their potential impact on credit losses, even small changes in forecasts can lead to significant adjustments in the reported allowance for credit losses and, consequently, earnings.