Potential Impact of CECL: Lending and the Economy
CECL could have a significant impact on the lending decisions of affected institutions.
As outlined in Part 1 of our series, the current expected credit loss (CECL) accounting standard — and its international counterpart IFRS9 — have their origins in the 2008 financial crisis and the Great Recession that followed. Given the significant economic damage that resulted from those events, the Financial Accounting Standards Board (FASB) first and foremost wished to ensure that financial statements accurately reflect the financial conditions of associated institutions. Shareholders, investors and analysts ultimately make their own determinations of risk and enterprise value, but it’s up to accounting and other financial professionals to provide them with timely, accurate information for their analysis. With deep knowledge of their institution’s lending and servicing practices, managers should be best positioned to provide an estimate of future loan losses to their constituents.
In the first two parts of this blog series, we discussed what CECL is and approaches to implementation. In this part, we discuss the implications of CECL on the business models of affected institutions and the broader economy.
Part 3: Impact of CECL on consumer lending and the economy
While not its direct intent, CECL could have a significant impact on the lending decisions of affected institutions. If firms need to reserve for losses earlier than they do now – even if the total amount of reserves were to remain unchanged – the change in timing alone could potentially lead to higher funding costs, which could ultimately get passed on to borrowers.
We consider three major channels for CECL to impact consumer lending and the broader economy:
- Product offerings: Will CECL affect the products lenders offer? Will credit availability be reduced?
- Moving from an incurred loss model with a relatively short loss emergence period to a lifetime loss model will have the greatest impact on longer term loans. This is due largely to a significant increase in their lifetime loss reserve estimates relative to short-term personal loans or commercial loans with typical terms of just a few years. Considering loan term in isolation, CECL would be expected to cause lenders to favor shorter term loans and increase the interest rate spread on longer term loans to cover their higher expense. [Read full overview.]
- Consistency in loss reserving and risk management across bank and nonbank lenders: Will CECL level the playing field across lenders? Will nonbanks be impacted more than regulated banks?
- CECL could potentially impact the financial system by leveling the playing field between bank and non-bank lenders. The financial crisis resulted in an increase in the capital requirements facing regulated banks and credit unions. While institutions decried the increased regulatory burden, these exercises were instrumental in restoring confidence in the banking system. At the same time, these regulatory burdens created an opportunity for non-bank institutions to expand into markets, such as personal loans and mortgages. With fewer regulatory requirements, non-bank lenders have been able to expand faster than traditional banks in some markets. As CECL will apply to all types of lending institutions, it should allow for greater comparability across the lending industry and curb some aggressive lending practices. [Read full overview.]
- Business cycle dynamics: Will CECL act as a countercyclical weight on lending standards? Or, will CECL be even more pro-cyclical than the current system?
- The greatest promise of CECL from a broader economic standpoint is the potential for it to act as a countercyclical weight in the credit cycle. Ideally, imposing greater recognition of losses earlier in the lifecycle of each loan should reduce the chance that lending standards loosen too much too quickly, as occurred during the housing boom of the last decade. Lenders learn about the outcome of their origination decisions with a long lag and are often making decisions on new loan applications well before they observe the results of their previous policies. The incurred loss model reinforces this lag by forcing lenders to wait to reserve until loan performance crosses a probable threshold of loss. By the time performance deteriorates, it is often too late to take remedial actions, making the process highly procyclical. CECL offers a mechanism for formally incorporating this dynamic directly into the loss reserving process by requiring a forward-looking view. [Read full overview.]
A Bumpy Road Ahead
While the implementation of CECL has the potential to provide investors with better information and strengthen the financial system, there are many details that will need to be worked out. How regulators will adjust capital calculations to account for CECL is a large unknown that could have large ramifications on the cost and availability of credit.
But the size of the task and chance of imperfection should not overshadow the benefits a more forward-looking system will bring. Just as occurred with the implementation of stress testing, CECL’s adoption is likely to be bumpy. It will take several years for lenders’ systems to mature and for auditors and regulators to agree on best practices. The transition won’t be costless, but when implemented correctly it should ultimately result in a stronger financial system that serves not only lenders and their shareholders, but borrowers as well.
For more information on how we can help your financial institution prepare for CECL, call your Equifax account representative, or contact us today. Additional resources can also be found on Equifax and Moody’s Analytics websites.
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