A story about enhancing Risk Management: Implementing CECL Model with Dynamic Macroeconomic Factors

Challenge:

The Current Expected Credit Loss (CECL) Model regulation was issued in June 2016 replacing the incurred loss standard. Under the incurred loss standard, credit losses were recognized once the occurrence of a loss event was determined probable (Chae, Sarama, Vojtech, & Wang, 2018). This accounting standard led to delayed recognition of losses resulting in rapid and volatile increases in provisions (Chae, Sarama, Vojtech, & Wang, 2018). Credit impairments and potential future losses were drastically underrepresented.CECL seeks to remedy this by estimating expected credit losses over the entire lifetime of loans at origination. Under CECL, financial entities must incorporate economic conditions to loss estimations. Forecasts of economic conditions used to predict expected loss must be reasonable and supportable.These new accounting standards apply to any institution issuing credit and have until January 2023 to be implemented in non-public companies.

Any institution issuing credit must now adhere to CECL regulations to estimate expected losses.

Proposed Solution

Analyze loan performance data, economic indicators, active borrowers behavior. Adequately segment clients into risk categories allowing for more precise tailoring of loss provisions to specific risk profiles, significantly enhancing the accuracy of expected loss estimates.

Develop a macroeconomic model that will predict how the current economic conditions (unemployment, inflation, GDP growth, etc.) can impact borrowers’s repayment behavior.

Integrate the macroeconomic impact into the the calculation of Lifetime Expected Loss for each active loan.

Results:

More precise expected loss estimations.

Lifetime expected loss calculations

Robust tool for accurately forecasting expected credit losses.

Dynamic incorporation of macroeconomic variables into the predictive models

Loss estimation is more dynamic.

• Regulatory Compliance and Financial Stability: The advanced CECL model not only ensures adherence to regulatory standards but also offers a more accurate depiction of financial risks, contributing to overall financial health.
• Precision in Forecasting: The use of cutting-edge modeling techniques and economic scenario planning allows for unprecedented accuracy in predicting credit losses.
• Informed Strategic Planning: Insights derived from the model enable financial institutions to make more strategic decisions regarding loan origination, risk management, and portfolio optimization.

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