CECL’s Forward-Looking Requirement: The Impact Could Be ...ma.moodys.com/rs/961-KCJ-308/images/CECLs Forward... · CECL’s Forward-Looking Requirements: The Impact Could Be Substantial,

CECL’s Forward-Looking Requirements:

The Impact Could Be Substantial

Cristian deRitis PhD, Senior Director, Economics

Timothy Daly, Director, Sales Manager

Dr. Cristian deRitis

Senior Director, Consumer Credit Analytics

Cristian deRitis, PhD, is a Senior Director with Moody’s Analytics specializing in

consumer credit analysis, policy and U.S. economic conditions.

Timothy Daly

Director, Sales Manager of Economics and Consumer Credit Analytics

Tim Daly, is a Director with Moody’s Analytics specializing in helping clients meet their

economic and consumer credit needs.

Presenters

This

changes

everything.

Source: FASB

http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176168232528&acceptedDisclaimer=true

CECL’s Forward-Looking Requirements: The Impact Could Be Substantial, Jan 2018 4

CECL in a

What’s it all about?

» The CECL standard will change how firms estimate their allowance for loan and lease losses

(ALLL).

» Addresses “too little too late” loss provisioning that occurred during the financial crisis.

» Replaces the current “incurred loss” standards–commonly known as FAS-5 and FAS-114.

» Applies to any entity issuing credit, including banks, credit unions and holding companies filing

under GAAP accounting standards.

» CECL will go into effect starting December 15, 2019, for public business entities that are U.S.

SEC filers.


» Under the incurred loss model, banks recognize losses when they reach a probable threshold

of loss.

» CECL removes the probable loss threshold and requires a lifetime credit loss allowance to

be established on day one of each exposure.

» Forecasting losses under CECL requires

- More granular data

- Enhanced credit models

- Forward-looking information or scenarios

Conceptual Differences


» Currently, losses are forecast over a loss emergence period.

» CECL is a lifetime loss estimate.

- Forecast losses over a reasonable and supportable horizon

- Extrapolate beyond this horizon using historical averages over the remaining life

» CECL standards are principles-based.

- Not prescriptive in how institutions address specific modeling challenges

- Flexibility to account for firms of different size and complexity

» Require increased transparency in assumptions and more disclosures to support the

allowance estimate.

» Selection of forecasts and assumptions will need quantitative support.

Biggest Change: Forecasting Losses


» CECL is more computationally intensive than the current method.

- Under the current standard, only a small subset of loans in the portfolio with a “high

probability of loss” are modeled

» Under CECL standard, we need to estimate and account for the potential losses from all

loans. CECL adds a probabilistic component.

» Given additional complexity, need efficiency gains to meet financial reporting deadlines:

- Better data management (centralized, scrubbed, QC checks)

- Enhanced execution performance (hardware, cloud)

- Models fit to purpose (optimize to produce required outputs)

- Specialization and outsourcing (buy vs. build trade-off)

Cost to Estimate ALLL Will Increase


“Allowances will double”

“Allowances will fall”

“You must build all of your own models”

“You can only forecast under one economic scenario”

“You must forecast under multiple economic scenarios”

“Auditors will demand more conservative estimates”

“CECL will force banks to only make short-term loans”

“CECL will cause all banks to be undercapitalized”

“CECL will push all lending to the shadow system”

“CECL will destroy the economy”

Dispelling Some CECL Myths


» Depends on a number of factors including

- Portfolio composition (longer-dated loans impacted more)

- Credit quality

- Geography

- Forward-looking forecast assumptions

- Stage of economic cycle

» As an exercise, we consider FDIC historical data on charge-offs and

allowances for all commercial banks

» Assume perfect foresight (that is, no model forecast error)

» Use residential mortgage vintage performance to calibrate lifetime loss

performance for CECL

» Just a thought exercise. Bank-specific results will vary!

How Will CECL Impact My Allowance?


Estimating the Impact: Default Rates Vary by Vintage Cohort5-yr cumulative net loss rate for first mortgage by origination qtr

Sources: CreditForecast.com, Moody’s Analytics

0

1

2

3

4

5

6

7

8

05 06 07 08 09 10 11 12

Avg=2.6%


0

50

100

150

200

250

300

05 06 07 08 09 10 11

By default yr

By origination yr

Poor quality and high

orig. volume in 2007

Charge-Offs Depend on Volume and PerformanceNet loan and lease charge-offs at commercial banks, $ bil

Sources: FDIC, Moody’s Analytics


0

50

100

150

200

250

05 06 07 08 09 10 11

Actual CECL estimate

Provision Expenses Front-Load With CECLProvision for loan and lease losses at commercial banks, $ bil


Would provisions

have changed

behavior?


0

50

100

150

200

250

300

05 06 07 08 09 10 11

Actual CECL estimate

Allowance for loan and lease losses at commercial banks, $ bil


ALLL should

better align with

credit quality

Allowance Balance (ALLL)


» Recognition of credit losses will

shift to an earlier point in the

credit cycle

» Current conditions will differ by

market (and type)

» The impact of conditions also

differ measurably

» Lack of data or lack of

quantitative support for

management estimates

Current Conditions

» Lifetime losses must be

recognized at origination, rather

than when default is deemed

likely

» Cumulative losses are non-

linear – how to measure?

» Prepayments are difficult to

measure, especially for

commercial portfolios

» Differences by loan types

Lifetime Losses

» Need to generate economic

scenarios

» Also, to appropriately link

scenarios to credit losses

» Ability to forecast beyond a

year or two into the future is a

challenge

» Unreliable forecasts will mean

greater volatility in loss

provisions

Supportable Forecasts

FASB’s 3 key considerations in estimating CECL

Biggest implementation challenge: Generating forward-looking scenarios

“The Biggest Change Ever” to Accounting


-5

-4

-3

-2

-1

0

1

2

3

4

5

15 16 17 18 19

BaselineS1S2S3S4S5S6

Real GDP, % change yr agoAvailable Scenarios

Standard-Driven

S1 Stronger Near-Term Rebound

BL Baseline Forecast

S2 Slower Near-Term Recovery

S3 Moderate Recession

S4 Protracted Slump

S5 Below-Trend Long-Term Growth

S6 Stagflation

S7 Next-Cycle Recession (U.S. Only)

S8 Low Oil Price

CS Constant Severity

CB Consensus Baseline (U.S. Only)

Compliance-Driven

FB Fed Baseline

FA Fed Adverse

FS Severely Adverse Scenario

BC Bank Specific Scenario

Manage Risk With Scenario AnalysisScenario service, monthly updates with narratives and probability weights

Source: Moody’s Analytics


Key Features

» Baseline forecast + eight alternative scenarios with probability weights

» Available for the U.S., all state and metro areas, as well as 60+ countries

» Coverage of more than 1,800 economic, financial and demographic variables

» Forecasts updated monthly, history updated in real-time, 30-year horizon

» Fully documented model methodology; scenario assumptions published monthly

» Back-testing, tracking and model validation reports available

Reasonable and supportable forecasts from Moody’s Analytics

Moody’s Analytics Scenarios


Based on sound, generally accepted economic and statistical theory

Incorporates inter-relationships and feedback effects among variables such

that a shock to one factor impacts all other factors over time

Provide information at varying levels of geographic aggregation to

capture local economic effects

Key considerations:

What Makes a Good Economic Forecast?

Our economic forecasting

model meets these criteria.


Approach used by use by Federal Reserve, IMF, Central Banks

Structural Forecast Model Methodology

Exchange rates

Investment

Wages and salaries

Po

pu

latio

n

Prices

GDP

Monetary policy rate

Imports

Government

Exports

Global GDP

Unemployment rate

Consumption

Labor force

Potential GDP

Banking sector

Import prices

10-yr yield

Global prices

Employment


Interrelationships between all key variables

Macro to Regional Linkages

Cost of Doing Business

Consumer Credit Quality

Output by Industry Employment by IndustryPopulation/Households

Labor Force/UnemploymentPersonal IncomeHousing

US MACRO MODEL


Use our collaborative forecasting platform

Want to Create Your Own Scenarios?

» Web-based application to develop your

own scenarios

» Uses Moody’s Analytics validated macro

models

» Forecast governance built into the

application core

– Audit trail of edits to forecast

assumptions

– Test edits in a sandbox environment

before committing them to the master

forecast

– Transparency of equations and

assumptions

» Collaborate with colleagues and/or

Moody’s Analytics on the same forecast

– Simultaneous read/write access


» No specific guidance – at least one forward look

– Could interpret as Baseline or Consensus scenario

» IFRS9 analogue to CECL

– Multiple, probability-weighted scenarios

» Measure loss under multiple scenarios

– Generate a distribution

» Given distribution of losses is skewed, multiple scenarios preferred

– “Average” economic forecast won’t generate the “average” level of losses

– Multiple scenarios approximate the distribution

Leverage percentile distributions using multiple scenarios

How Many Scenarios Do You Need?


3

4

5

6

7

8

9

10

11

12

13

0 12 24 36

Initial forecast

Realized

Update 1

Update 2

Unemployment rate, %

Sources: BLS, Moody’s Analytics

X-axis: mo from start of forecast

Single, Consensus Unemployment Forecasts


0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0 12 24 36

Consensus

Update 1

Update 2

Single Scenario: Loss Forecasts Volatile Under ConsensusLoss rate, %

X-axis: mo on book (age)



Multiple Scenarios: Probability Weighted Forecasts

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

0 12 24 36 48 60

Baseline

S1: Optimistic

S3: Pessimistic

Prob Weighted

30% wgt

40% wgt30% wgt

Loss rate, %




0.0

0.1

0.2

0.3

0.4

0.5

0.6

0 12 24 36

Prob Weighted

Update 1

Update 2

Multiple Scenarios: Loss Forecast Updates Less VolatileLoss rate, %

Sources: BEA, Moody’s Analytics



Recommendations

1. For the largest institutions:

» Multiple custom economic scenarios provide a wide range of estimates.

» Estimates less sensitive to decisions on forecast period and mean reversion.

» Multiple scenarios reduce volatility in quarter-to-quarter updates.

2. For midsize institutions:

» Standardized economic forecasts provide a reasonable solution.

» Multiple, risk-weighted scenarios provide a quantitative, defensible approach.

» Multiple scenarios reduce volatility in quarter-to-quarter updates.

3. For smaller institutions:

» A single scenario approach is reasonable.

» “Reasonable and supportable” forecast horizon at 2-3 years with gradual reversion..

» Run periodic sensitivity analysis to disclose potential volatility/risks to the forecast.

Different approaches for different situations


Moody’s Analytics CECL Solution Suite

moodysanalytics.com

United States

121 North Walnut Street

Suite 500

West Chester PA 19380

+1.610.235.5299

United Kingdom

One Canada Square

Canary Wharf

London E14 5FA

+44.20.7772.5454

Australia

Level 10

1 O'Connell Street

Sydney, NSW, 2000

Australia, +61.2.9270.8111

Prague

Washingtonova 17

110 00 Prague 1

Czech Republic

+420.22.422.2929


© 2018 Moody’s Corporation, Moody’s Investors Service, Inc., Moody’s Analytics, Inc. and/or their licensors

and affiliates (collectively, “MOODY’S”). All rights reserved.

CREDIT RATINGS ISSUED BY MOODY'S INVESTORS SERVICE, INC. AND ITS RATINGS AFFILIATES

(“MIS”) ARE MOODY’S CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES,

CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES, AND MOODY’S PUBLICATIONS MAY

INCLUDE MOODY’S CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES,

CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES. MOODY’S DEFINES CREDIT RISK

AS THE RISK THAT AN ENTITY MAY NOT MEET ITS CONTRACTUAL, FINANCIAL OBLIGATIONS AS

THEY COME DUE AND ANY ESTIMATED FINANCIAL LOSS IN THE EVENT OF DEFAULT. CREDIT

RATINGS DO NOT ADDRESS ANY OTHER RISK, INCLUDING BUT NOT LIMITED TO: LIQUIDITY RISK,

MARKET VALUE RISK, OR PRICE VOLATILITY. CREDIT RATINGS AND MOODY’S OPINIONS

INCLUDED IN MOODY’S PUBLICATIONS ARE NOT STATEMENTS OF CURRENT OR HISTORICAL

FACT. MOODY’S PUBLICATIONS MAY ALSO INCLUDE QUANTITATIVE MODEL-BASED ESTIMATES

OF CREDIT RISK AND RELATED OPINIONS OR COMMENTARY PUBLISHED BY MOODY’S

ANALYTICS, INC. CREDIT RATINGS AND MOODY’S PUBLICATIONS DO NOT CONSTITUTE OR

PROVIDE INVESTMENT OR FINANCIAL ADVICE, AND CREDIT RATINGS AND MOODY’S

PUBLICATIONS ARE NOT AND DO NOT PROVIDE RECOMMENDATIONS TO PURCHASE, SELL, OR

HOLD PARTICULAR SECURITIES. NEITHER CREDIT RATINGS NOR MOODY’S PUBLICATIONS

COMMENT ON THE SUITABILITY OF AN INVESTMENT FOR ANY PARTICULAR INVESTOR. MOODY’S

ISSUES ITS CREDIT RATINGS AND PUBLISHES MOODY’S PUBLICATIONS WITH THE EXPECTATION

AND UNDERSTANDING THAT EACH INVESTOR WILL, WITH DUE CARE, MAKE ITS OWN STUDY AND

EVALUATION OF EACH SECURITY THAT IS UNDER CONSIDERATION FOR PURCHASE, HOLDING,

OR SALE.

MOODY’S CREDIT RATINGS AND MOODY’S PUBLICATIONS ARE NOT INTENDED FOR USE BY

RETAIL INVESTORS AND IT WOULD BE RECKLESS AND INAPPROPRIATE FOR RETAIL INVESTORS

TO USE MOODY’S CREDIT RATINGS OR MOODY’S PUBLICATIONS WHEN MAKING AN

INVESTMENT DECISION. IF IN DOUBT YOU SHOULD CONTACT YOUR FINANCIAL OR OTHER

PROFESSIONAL ADVISER.

ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY LAW, INCLUDING BUT NOT LIMITED TO,

COPYRIGHT LAW, AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE

REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED,

REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN

WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY

PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT.

All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and

reliable. Because of the possibility of human or mechanical error as well as other factors, however, all

information contained herein is provided “AS IS” without warranty of any kind. MOODY'S adopts all

necessary measures so that the information it uses in assigning a credit rating is of sufficient quality and from

sources MOODY'S considers to be reliable including, when appropriate, independent third-party sources.

However, MOODY’S is not an auditor and cannot in every instance independently verify or validate

information received in the rating process or in preparing the Moody’s publications.

To the extent permitted by law, MOODY’S and its directors, officers, employees, agents, representatives,

licensors and suppliers disclaim liability to any person or entity for any indirect, special, consequential, or

incidental losses or damages whatsoever arising from or in connection with the information contained herein

or the use of or inability to use any such information, even if MOODY’S or any of its directors, officers,

employees, agents, representatives, licensors or suppliers is advised in advance of the possibility of such

losses or damages, including but not limited to: (a) any loss of present or prospective profits or (b) any loss or

damage arising where the relevant financial instrument is not the subject of a particular credit rating assigned

by MOODY’S.

To the extent permitted by law, MOODY’S and its directors, officers, employees, agents, representatives,

licensors and suppliers disclaim liability for any direct or compensatory losses or damages caused to any

person or entity, including but not limited to by any negligence (but excluding fraud, willful misconduct or any

other type of liability that, for the avoidance of doubt, by law cannot be excluded) on the part of, or any

contingency within or beyond the control of, MOODY’S or any of its directors, officers, employees, agents,

representatives, licensors or suppliers, arising from or in connection with the information contained herein or

the use of or inability to use any such information.

NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS,

MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR

OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER

WHATSOEVER.

Moody’s Investors Service, Inc., a wholly-owned credit rating agency subsidiary of Moody’s Corporation

(“MCO”), hereby discloses that most issuers of debt securities (including corporate and municipal bonds,

debentures, notes and commercial paper) and preferred stock rated by Moody’s Investors Service, Inc. have,

prior to assignment of any rating, agreed to pay to Moody’s Investors Service, Inc. for appraisal and rating

services rendered by it fees ranging from $1,500 to approximately $2,500,000. MCO and MIS also maintain

policies and procedures to address the independence of MIS’s ratings and rating processes. Information

regarding certain affiliations that may exist between directors of MCO and rated entities, and between entities

who hold ratings from MIS and have also publicly reported to the SEC an ownership interest in MCO of more

than 5%, is posted annually at www.moodys.com under the heading “Investor Relations — Corporate

Governance — Director and Shareholder Affiliation Policy.”

Additional terms for Australia only: Any publication into Australia of this document is pursuant to the

Australian Financial Services License of MOODY’S affiliate, Moody’s Investors Service Pty Limited ABN 61

003 399 657AFSL 336969 and/or Moody’s Analytics Australia Pty Ltd ABN 94 105 136 972 AFSL 383569

(as applicable). This document is intended to be provided only to “wholesale clients” within the meaning of

section 761G of the Corporations Act 2001. By continuing to access this document from within Australia, you

represent to MOODY’S that you are, or are accessing the document as a representative of, a “wholesale

client” and that neither you nor the entity you represent will directly or indirectly disseminate this document or

its contents to “retail clients” within the meaning of section 761G of the Corporations Act 2001. MOODY’S

credit rating is an opinion as to the creditworthiness of a debt obligation of the issuer, not on the equity

securities of the issuer or any form of security that is available to retail investors. It would be reckless and

inappropriate for retail investors to use MOODY’S credit ratings or publications when making an investment

decision. If in doubt you should contact your financial or other professional adviser.

Additional terms for Japan only: Moody's Japan K.K. (“MJKK”) is a wholly-owned credit rating agency

subsidiary of Moody's Group Japan G.K., which is wholly-owned by Moody’s Overseas Holdings Inc., a

wholly-owned subsidiary of MCO. Moody’s SF Japan K.K. (“MSFJ”) is a wholly-owned credit rating agency

subsidiary of MJKK. MSFJ is not a Nationally Recognized Statistical Rating Organization (“NRSRO”).

Therefore, credit ratings assigned by MSFJ are Non-NRSRO Credit Ratings. Non-NRSRO Credit Ratings are

assigned by an entity that is not a NRSRO and, consequently, the rated obligation will not qualify for certain

types of treatment under U.S. laws. MJKK and MSFJ are credit rating agencies registered with the

Japan Financial Services Agency and their registration numbers are FSA Commissioner (Ratings) No. 2

and 3 respectively.

MJKK or MSFJ (as applicable) hereby disclose that most issuers of debt securities (including corporate and

municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MJKK or MSFJ (as

applicable) have, prior to assignment of any rating, agreed to pay to MJKK or MSFJ (as applicable) for

appraisal and rating services rendered by it fees ranging from JPY200,000 to approximately

JPY350,000,000.

MJKK and MSFJ also maintain policies and procedures to address Japanese regulatory requirements.


Selected Case Studies

INSTITUTION OVERVIEW

Large Multinational GSIB

(Asset Size = $386B)

Produced stressed BHC scenario based on counterparty default and three Fed scenariosthrough a network of ~1000 macroeconomic and global financial market factors.

Footprint: International, Market Risk, U.S. subnational specialty

CCAR Bank


Met with C suite to assess client’s risk profile including C&I concentrations and retail mix.Proposed three idiosyncratic scenarios for their CCAR submission (ex yield curve inverts,Fed tightens monetary policy too soon, nuclear reactor accident)

Footprint: U.S. and select States

Merchant Services

(Asset Size = $33B)

Partnered with client’s risk management team to build IFRS 9 compliant models for all oftheir portfolios and provided access to our probability-weighted scenarios for use in themodels. CECL modeling to start in 2018.

Footprint: U.S., select States and Metros, International

Captive Finance


Assisted with scenario and model development for IFRS 9 providing access to off-the-shelfscenarios and built IFRS 9 compliant model for auto loan portfolio.

Footprint: Canada, select Provinces and Metros in Canada

DFAST Bank

(Asset Size = $26B)

Partnering with client’s CECL working group and stress-test team to provide off-the-shelfscenarios highlighting key risks in CRE, C&I, and mortgages.

Footprint: U.S., select States and Metros in the Midwest


CECL Scope and Timeline

2017

Project Plan/

Governance

Structure

Mid-2017

Gap Analysis

Preliminary

Decisions

2019

Early Adoption?

2020

SEC Filers

Mid-2018

Models and

Methodology

2019

Parallel Run

2018

End-To-End

Solution

Implementation

» Scope: financial instruments measured at amortized cost basis

– Loans held for investment

– Debt securities held to maturity

– Net investment in leases

– Off balance sheet exposures (loan commitments, letters of credit)

– Other (trade and reinsurance receivables, off-balance-sheet exposures)

» AFS OTTI model is changed to Allowance model

» Measure expected credit losses over the life of financial asset based on:

– Past events, including historical experience

– Current conditions

– Reasonable and supportable forecasts

» New disclosure requirements: amortized cost by credit quality indicators and vintage

» Current processes can be leveraged, but there are a number of considerations

– Internal credit risk systems

– Incurred loss ALLL processes

– DFAST processes


Key Decisions for Computing CECL

• Which methods are acceptable?

• Can I leverage existing models?Data and

Methodology

• Contractual or behavioral life?

• Life of revolving account?Lifetime Definition

• What’s required? Best practice?

• What are options for retail credit?Model Backtesting and Benchmarking

• Which scenario is defensible?

• How many?Economic Scenarios

Source: Moody’s Analytics


Industry Survey: What Is the Most Significant Challenge

Anticipated?Model-related issues consistently rank high

32%

27%

18%

11%

2%10%

February 2017

Data availability

ECL quantification

Scenario design

Qualitative overlay methodology

Performance (i.e. speed of execution)

Data and process governance

35%

18%

37%

10%

August 2017

Data availability

Scenario selection, design and support

Expected credit loss methodology

Process governance and controls

Documents

CECL’s Forward-Looking Requirement: The Impact Could Be ...ma.moodys.com/rs/961-KCJ-308/images/CECLs Forward... · CECL’s Forward-Looking Requirements: The Impact Could Be Substantial,