Potential Impact of CECL: Consumer Lending
As lenders transition to the new accounting standard, the changes anticipated from the current expected credit loss (CECL) implementation are vast. In this post, we discuss the potential impact on 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?
Leaning Against the Wind
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 lending and servicing process should reduce the chance that lending standards loosen too much too quickly as occurred during the housing boom of the last decade.
To illustrate CECL’s potential impact, consider the credit cycle characterized by four phases:
- Expansion – wherein outstanding balances rise along with delinquency rates
- Slowing – wherein balances contract as lenders start to pull back, but delinquency rates rise
- Contraction – wherein outstanding balances contract with delinquency rates
- Acceleration – wherein balances rise as lenders start to loosen, but delinquency rates remain low
4 Phases of the Credit Cycle for Auto Loans and Leases
Sources: Equifax, Moody’s Analytics
The credit cycle itself is a result of the lagged nature between credit decisions and observed outcomes. That is, when a lender originates a loan and the borrower starts to pay, it may take years for the lender to observe whether the borrower pays back the debt or defaults. As a result, it may be difficult for individual lenders to incorporate broader trends in the credit cycle into their individual lending decisions in real time. When times are good, lenders will be under pressure to increase volume and market-share. Conversely when times are bad, shareholders will demand conservatism.
CECL offers a mechanism for formally incorporating this dynamic directly into the loss reserving process such that it acts as a countercyclical signal. In addition to reflecting the portfolio composition, expected loss estimates should rise as the probability of a correction or economic recession increases.
For example, if house prices historically have grown at 3% per year but are suddenly growing at 10% per year, the likelihood of a correction or a return to long run trend should be higher. The higher loss reserves required as a result should lead lenders to tighten up their lending standards. CECL’s shift in timing should force lenders to deal with the possibility of higher losses when they are best positioned to prevent them – at loan origination.
In theory, CECL sounds wonderful and eventually it should be.
However, as discussed in Part 2 of our series, the outcome of CECL on individual lenders and the economy more broadly depends heavily on the underlying assumptions lenders will use in their calculations. CECL’s principles-based approach offers tremendous flexibility, but also runs the risk that firms will not interpret the rules in a manner that benefits the overall system.
Take the use of forward-looking economic scenarios. Lenders could take the approach of using a benign, single “most-likely” scenario based on consensus views of where the economy is headed over the next year or two. Such an approach may meet a strict interpretation of being “reasonable and supportable,” but falls short of a more realistic view that should consider the possibility that the economy could fall into recession. Recognizing this, auditors, regulators and investors will be paying close attention to the economic forecast assumptions behind an institution’s CECL estimates. Overly optimistic views will be much easier to spot given CECL’s disclosure requirements.
As a countercyclical weight that encourages lenders to increase their loss reserves in good times, CECL holds tremendous promise over the current system. However, there is a risk that lenders will not consider a spectrum of potential outcomes when setting their forward-looking reserves. At worst, lenders could take a naïve, short-sighted view and forecast the future based on recent history – similar to the existing incurred loss model. Knowing this, auditors and regulators will require more holistic views of losses, thereby preserving CECL’s countercyclical qualities.
To view additional potential impacts of CECL on consumer lending and the broader economy, read the full blog, “Potential impact of CECL.”
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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