12.1 Expected Credit Loss Models and Their Application
3 min read•august 7, 2024
() models are crucial in financial reporting for estimating potential losses on loans and other financial instruments. These models consider factors like default probability and loss severity to provide a more accurate picture of an institution's financial health.
and are two major ECL frameworks used globally. While they share similarities in forward-looking approaches, they differ in implementation details. Understanding these models is key to grasping modern financial risk management and reporting practices.
Credit Loss Measurement Models
Expected Credit Loss (ECL) Models
Expected Credit Loss (ECL) represents the weighted average of credit losses with the respective risks of a default occurring as the weights
IFRS 9 is an International Financial Reporting Standard that addresses the accounting for financial instruments and requires the application of an ECL model for recognizing
CECL (Current Expected Credit Loss) is a credit loss accounting standard that requires recognition of expected credit losses over the life of the loan at the time of origination
considers the within the next 12 months and is used for financial instruments that have not had a significant increase in credit risk since initial recognition
takes into account the expected credit losses that result from all possible default events over the expected life of a financial instrument and is used when there has been a significant increase in credit risk
Comparison of ECL Models
IFRS 9 and CECL both require the use of in estimating expected credit losses
IFRS 9 uses a three-stage approach to classify financial assets based on credit risk, while CECL applies to all financial assets measured at amortized cost
IFRS 9 recognizes 12-month ECL for Stage 1 assets and lifetime ECL for Stage 2 and 3 assets, whereas CECL requires the recognition of lifetime ECL for all assets at origination
IFRS 9 allows for the reversal of previously recognized impairment losses if credit risk improves, while CECL does not permit the reversal of previously recognized losses
Key Components of ECL Models
Probability of Default (PD)
Probability of Default () represents the likelihood that a borrower will default on their obligation within a specified time horizon
PD is typically estimated using historical default data, credit ratings, and other relevant information about the borrower
PD can be calculated for different time horizons, such as 12 months or the lifetime of the financial instrument
Factors influencing PD include the borrower's financial health, economic conditions, and industry trends
Loss Given Default (LGD) and Exposure at Default (EAD)
() is the percentage of the exposure that is expected to be lost if a default occurs
LGD takes into account the value of any collateral or other credit enhancements that may mitigate losses
() represents the total amount owed by the borrower at the time of default
EAD includes the outstanding principal, accrued interest, and any other fees or charges
LGD and EAD are used in conjunction with PD to calculate the expected credit loss (ECL = PD × LGD × EAD)
Interest Rate Considerations
Effective Interest Rate (EIR) and Its Impact on ECL
() is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the gross carrying amount of the financial asset
EIR is used to calculate interest income and is adjusted for any transaction costs, fees, or other premiums or discounts
When calculating ECL, the cash flows used should be consistent with those used in determining the EIR
Changes in expected cash flows due to credit risk are reflected in the ECL, while changes in expected cash flows due to other factors (such as interest rate changes) are reflected in the EIR
The interaction between EIR and ECL ensures that interest income is recognized based on the gross carrying amount of the financial asset, less any ECL allowance
Key Terms to Review (29)
12-month ECL: The 12-month Expected Credit Loss (ECL) is a financial metric that estimates the potential losses from default on financial assets over the next 12 months. This concept is crucial in assessing credit risk and is part of a broader framework used for measuring credit losses, which supports more forward-looking risk management and enhances transparency in financial reporting.
Banks: Banks are financial institutions that accept deposits from the public, provide loans, and offer various financial services. They play a critical role in the economy by facilitating transactions, managing risk, and ensuring liquidity in the financial system. Through stress testing and scenario analysis, banks assess their resilience to economic shocks, while expected credit loss models help them estimate potential losses from defaulting loans.
Basel III: Basel III is an international regulatory framework established to strengthen the regulation, supervision, and risk management of banks. It builds upon previous agreements and introduces more stringent capital requirements, liquidity standards, and measures to enhance financial stability, ensuring that banks can better withstand economic stress and reduce the likelihood of financial crises.
CECL: CECL, or Current Expected Credit Loss, is an accounting standard that requires financial institutions to estimate and recognize expected credit losses over the life of a financial asset at the time of origination. This proactive approach shifts the focus from incurred losses to expected losses, enhancing the transparency and timeliness of credit loss recognition in financial reporting.
Credit loss allowance: A credit loss allowance is an estimation of the potential losses a financial institution might face due to borrowers defaulting on loans or not fulfilling their payment obligations. This allowance is crucial as it directly affects the financial health of lending institutions by providing a buffer against expected losses and ensuring compliance with accounting standards. The concept plays a vital role in expected credit loss models, which aim to assess the risk of credit losses over time based on various economic factors and borrower characteristics.
Credit Unions: Credit unions are member-owned financial cooperatives that provide a range of financial services, including savings accounts, loans, and other banking services, primarily to their members. They operate on the principle of mutual benefit, meaning that profits are returned to members in the form of lower fees, higher interest rates on deposits, and lower rates on loans, fostering a community-oriented approach to finance.
EAD: EAD, or Exposure at Default, refers to the total amount of money a lender stands to lose if a borrower defaults on a loan. It is a critical component in calculating credit risk, as it helps financial institutions estimate the potential loss they may face if a borrower fails to repay their obligations. Understanding EAD is essential for effective risk management and is often used in conjunction with other metrics like Probability of Default (PD) and Loss Given Default (LGD) to assess overall credit risk exposure.
ECL: ECL, or Expected Credit Loss, is a financial term that refers to the anticipated loss a lender may incur if a borrower defaults on a loan. This concept is critical for financial institutions as it helps them assess the risk of their credit portfolios and set aside adequate reserves. ECL models are essential for complying with accounting standards and provide a forward-looking approach to managing credit risk, emphasizing the importance of timely recognition of potential losses.
Economic downturn: An economic downturn is a period of reduced economic activity characterized by falling GDP, rising unemployment rates, and declining consumer spending. During such times, businesses may experience lower revenues and profitability, prompting them to reassess their asset valuations and financial reporting. This context significantly influences how companies measure fair value, assess expected credit losses, and consider broader macroeconomic factors in their forecasts.
Effective Interest Rate: The effective interest rate is the true cost of borrowing or the true yield on an investment, expressed as an annual percentage rate that accounts for compounding over a given time period. It reflects the actual financial impact of interest charges or earnings on a loan or investment, taking into consideration the effects of compounding that occur during the year.
EIR: EIR, or Effective Interest Rate, refers to the true cost of borrowing or the actual yield on an investment, expressed as an annual percentage rate that takes into account the effects of compounding. It is important for understanding the financial impact of loans and investments over time, as it allows for a comparison between different financial products that may have varying compounding periods. By providing a more accurate representation of interest, EIR helps individuals and institutions make informed financial decisions.
Expected Credit Loss: Expected credit loss refers to the estimate of the likelihood of a borrower defaulting on a loan, taking into account the potential loss incurred if default occurs. This concept is essential for financial institutions to assess and recognize credit risk accurately, especially in the shift from older accounting standards that did not require proactive loss recognition. It plays a crucial role in understanding credit risk, calculating provisions, and ensuring transparent financial reporting.
Exposure at Default: Exposure at Default (EAD) refers to the total value that a financial institution is exposed to at the time of a borrower's default. This term is crucial for calculating credit risk and assessing potential losses in lending situations. Understanding EAD helps institutions determine how much capital to hold against potential losses, which is essential for maintaining financial stability and complying with regulatory requirements.
FASB Standards: FASB Standards are a set of accounting principles and guidelines established by the Financial Accounting Standards Board (FASB) to govern financial reporting in the United States. These standards ensure consistency, transparency, and comparability in financial statements, which is essential for stakeholders to make informed decisions. FASB Standards are crucial in areas such as revenue recognition, lease accounting, and expected credit loss models, influencing how financial institutions manage and report their assets and liabilities.
Financial statement footnotes: Financial statement footnotes are supplementary explanations or disclosures that accompany a company's financial statements, providing additional context and details that enhance the understanding of the financial position and performance. These footnotes are crucial for offering insights into accounting policies, contingent liabilities, and any significant events affecting the company's financial health. They play a key role in transparency, ensuring that stakeholders have a complete view of the financial statements, especially in areas like expected credit loss models.
Forward-looking information: Forward-looking information refers to estimates and projections about future events, conditions, or performance that are based on current data and assumptions. This type of information plays a crucial role in assessing risk and making informed decisions, especially in financial contexts where anticipating future credit losses or impairments is essential for effective risk management.
Historical loss rates: Historical loss rates refer to the percentage of losses experienced by a financial institution over a specific period, which is used to estimate future credit losses. This metric is essential in assessing the credit risk associated with lending and investment portfolios, as it provides a baseline for expected losses based on past performance. By analyzing historical data, institutions can develop more accurate expected credit loss models that inform their financial reporting and risk management strategies.
IFRS 9: IFRS 9 is an international financial reporting standard that provides guidelines for the classification, measurement, impairment, and hedge accounting of financial instruments. It was developed to enhance the transparency and consistency of financial reporting, addressing issues present in previous standards by introducing more forward-looking approaches to credit losses and clearer rules for financial asset classification.
Impairment losses: Impairment losses occur when the carrying amount of an asset exceeds its recoverable amount, indicating that the asset has lost value and is no longer worth its recorded cost. This concept is crucial for ensuring that financial statements accurately reflect the current economic reality, especially in the context of evaluating credit risks and potential losses associated with financial assets.
LGD: LGD, or Loss Given Default, is a key metric used in credit risk management to estimate the potential loss that a lender might incur if a borrower defaults on a loan. It represents the percentage of the total exposure that is expected to be lost, factoring in recovery rates from collateral or other forms of security. Understanding LGD is essential for developing accurate expected credit loss models, as it helps in quantifying the financial impact of defaults and influences capital allocation and pricing decisions for lenders.
Lifetime ecl: Lifetime expected credit loss (ECL) is a financial metric that estimates the total expected credit losses over the life of a financial asset, accounting for all potential defaults. This concept is crucial in the context of credit risk management, as it provides a forward-looking view on potential losses, allowing institutions to better prepare for and mitigate risks associated with lending and investment activities.
Loan Loss Provision: A loan loss provision is an expense set aside by a financial institution to cover potential losses from loans that may not be repaid. This provision acts as a financial buffer, reflecting the lender's expectations regarding future credit losses based on historical data, current conditions, and forecasts. By accounting for these potential losses, institutions can maintain a more accurate picture of their financial health and ensure compliance with regulatory requirements.
Loss Given Default: Loss Given Default (LGD) is a financial metric that estimates the potential loss a lender would incur if a borrower defaults on a loan, expressed as a percentage of the total exposure at default. This concept is essential in assessing credit risk, as it helps financial institutions determine the likelihood and extent of potential losses in the event of borrower default. LGD plays a critical role in impairment models and expected credit losses, influencing how banks set aside capital reserves and report their credit risk exposure.
Market volatility: Market volatility refers to the degree of variation in the price of a financial asset over time, often measured by standard deviation or variance. It signifies the amount of uncertainty or risk involved in the size of changes in a security's value, which can be influenced by various factors such as economic indicators, geopolitical events, and investor sentiment. Understanding market volatility is crucial for managing liquidity and funding strategies, implementing effective hedging techniques, and estimating potential credit losses in financial reporting.
Pd: In the context of expected credit loss models, 'pd' stands for probability of default, which refers to the likelihood that a borrower will fail to meet their debt obligations over a specified time frame. This metric is crucial for financial institutions as it helps in assessing credit risk, determining capital reserves, and calculating expected credit losses under various accounting standards.
Probability of Default: The probability of default is a financial term that quantifies the likelihood that a borrower will fail to meet their debt obligations within a specified time frame. This metric is critical in assessing credit risk, as it influences the estimation of expected credit losses and impairment models used by financial institutions. Understanding the probability of default helps institutions to set appropriate provisions for potential losses and adhere to regulatory disclosure requirements regarding credit risk.
Regulatory frameworks: Regulatory frameworks are structured sets of guidelines and rules established by governing bodies to ensure compliance, manage risks, and protect the integrity of financial systems. These frameworks play a vital role in shaping how institutions operate, especially in response to economic challenges and credit risk, ultimately influencing expected credit loss models and their application in financial reporting.
Risk Management Disclosures: Risk management disclosures are the reports and statements that organizations provide to communicate their exposure to various risks, how they manage those risks, and the effectiveness of their risk management strategies. These disclosures help stakeholders understand the organization's financial health and operational stability by detailing the methods used to identify, assess, and mitigate risks, particularly in relation to financial instruments and credit risk management.
Write-offs: Write-offs refer to the formal recognition that a portion of an asset is no longer recoverable, which often results from credit losses or the uncollectibility of accounts receivable. This process is crucial for accurately representing the financial health of an organization, especially in the financial services industry, where understanding expected credit losses is essential for proper risk management and regulatory compliance.