The CECL Handbook: A Practitioner’s Guide
First published:
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Early view of CECL integration into stress testing: practical approaches
Ken Carson and Francisco Covas
Introduction
An overview of CECL: setting the context
Outlining the most impactful assumptions and challenges under CECL: an auditor’s view
Outlining the most impactful assumptions and challenges under CECL: a banker’s view
A banking industry perspective on key CECL decisions
Challenges and solutions for wholesale portfolios
Challenges and solutions for retail mortgage portfolios
Challenges and solutions for retail credit card portfolios
Challenges and solutions for student loans
Challenges and solutions for securities portfolios
The evolution of purchased loan accounting: from FAS 91 to the CECL transition
Challenges and solutions for qualitative allowance
Challenges and solutions: an auditor’s point of view
Early view of CECL integration into stress testing: practical approaches
Too many cooks in the kitchen: mastering the art of managing CECL volatility
Beyond CECL: rethinking bank transformation
Data collision: efficient lending under CECL
Cutting through the hype: how CECL is impacting investor views of procyclicality, credit analysis and M&A
Concentration risk: the CECL magnifying glass
Closing thoughts
This chapter will analyse several important challenges to the integration of the current expected credit loss (CECL) standard into stress testing. First, we calculate the size of the increase in allowance for loan and lease losses (ALLL) and the common equity Tier 1 (CET1) capital ratio due to the perfect-foresight assumption for a representative bank. We then discuss a few approaches that can be applied to offset the increase in capital requirements. Under CECL, the calculation of loan loss allowances depends significantly on forecasts of the business cycle over a medium-run horizon. As a bank goes through each period of the stress scenario horizon, it needs to generate a new baseline macroeconomic scenario to calculate CECL-based allowances. In practice, the requirement to generate a new baseline macroeconomic scenario increases the complexity and subjectivity of stress testing.
The assumption of perfect foresight circumvents the need to develop a new baseline scenario in each period of the planning horizon since, under this assumption, we know exactly how the future will unfold. However, the assumption of perfect foresight increases capital depletion under stress, as banks
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