Potential Impact of CECL: Product Offerings
In this post, we continue to explore the potential impacts of the current expected credit loss (CECL) standard on both consumer lending and the broader economy, with a focus on the potential impact of the new standard on product offerings in particular.
- Will CECL affect the products lenders offer?
- Will credit availability be reduced?
Shorter Loan Terms?
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. In particular, mortgage and student loans with contractual terms of 10, 15 or even 30 years will see a significant increase in their loss reserve estimates as compared to short-term personal loans or commercial loans with typical terms of just a few years. Loans with extremely short terms could experience no change in their reserve estimates and could actually see them decline in some instances.
Loss estimates under CECL should account for early payoffs, so the effective term for a 30 year fixed rate mortgage may be closer to 7 or 10 years given the tendency of borrowers to move or refinance their loans. While this helps to decrease the time of exposure, the difference from the current system, which may focus on a loss emergence period of a year or two, is substantial.
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 allowance expense. Similarly, the cost for higher risk loans to subprime borrowers may rise since the likelihood of default is greater than for prime borrowers. As a result, lenders may need to set aside more money for this transaction with respect to the CECL standard. Credit availability may be reduced as a result.
From the standpoint of the overall financial system, loans with shorter loan terms could provide a better match with the liabilities on lenders’ balance sheets, thereby making the financial system stronger and more resilient to changes in interest rates. Notably, many previous recessions have either been caused by or aggravated by banks’ struggles to remain profitable or solvent when their short-term funding rates rise above their long-term lending rates. The inversion of the yield curve has presaged every recession since 1950 in part because of the strain it puts on the banking system.
Sources: Treasury, Moody’s Analytics
The flipside of reducing the risk for banks is that borrowers may bear more of the interest rate risk. For example, borrowers may be incentivized to take out shorter term mortgages that they will need to refinance periodically as is done in Canada. Or, they may need to pay a somewhat higher interest rate for the peace of mind of locking it in for 30 years. Ultimately, CECL’s impact on the products that lenders offer will depend on how it is implemented and how borrowers and financial markets react and adjust to the changes. If CECL results in less uncertainty or lowers the probability that a lender will become insolvent, then the lender may benefit from lower funding costs that offset the increased cost of reserving for losses earlier.
While the lifetime aspect of CECL may favor shorter term loans, the impact is likely to be small once all of the costs and benefits are accounted for. Government support of the residential mortgage and student loan markets will insure that longer terms loans will continue to be available to borrowers.
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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