CECL vs. CCAR: A Significant Change in the Banking Industry

In an effort to  reinforce the financial system, The FASB (Financial Accounting Standard Board) releases  new regulations and policies from time to time. To ensure that financial institutions have liquidity in the times of extreme stress, CECL was released in addition to CCAR for capital adequacy.

CCAR and CECL

CCAR serves to ensure that banks would have sound capital planning in place and could survive key changes in the macroeconomic indicators that are influential.

CECL, on the other hand, is a component required for formulating a CCAR, in which FASB has replaced the accounting head of ‘incurred loss’ with ‘expected loss’ model.

 All the loans that a bank has underwritten need to be stress-tested from the day the underwriting has been done. The payment schedule along with principal payments has to be tested on regular basis to see if they are being repaid on time. If not, then the bank needs to mention them as bad debts, insure them so the bank doesn’t have to bear the default risk, or pay them off from their available excess cash reserves so as to balance the sheets.

This step has been taken after the delayed realization of credit losses in 2008 that led to the collapse of some of the most reputed and biggest banks, with a few being bailed out by the government considering them as ‘Too Big to Fail’.

Differences Between CCAR and CECL

Although CECL has many similarities to CCAR, there are a few key differences that cannot be neglected. CCAR models are actually a good starting point for CECL models and purposes.

In CCAR, banks are required to use the data available as of the end of December for the stress-testing process that is done bi-annually over a period of 3 months. Whereas CCEL is more accounting oriented and is done over a set period of time for the loan that is under analysis. And since stress testing is a broader exercise, it is not relevant to CECL.

One of the requirements that CECL requires, which was not necessarily required in CCAR, is better adjustments of baseline estimates which are well aligned and are in coordination with the banks or financial institutions forecasts for capitals and loan repayments. It further requires for the business to be able to deal with longer time horizons and maintain data for longer periods of time because of the life of the loan forecast that is estimated before handing out a loan, and better incorporation of prepayment models necessary to determine the expected life of the loan.

Another difference between CECL and CCAR is that CCAR allows the availability of time that can vary in different financial institutions. The scenario analysis and stress testing processes might take time and can be performed in a couple of weeks. However, in CECL the process needs to be completed in a few days as it is compressed for the time because it needs to be done every quarter.

Further, it has been observed that CCAR models are more based on PIT (Point IN Time) models and therefore are driven by macroeconomic factors. Also, the TTC (Through the Cycle) models are considered to be backward looking as the incorporate default historic experiences which do not make it suitable for CECL. For this reason, a new approach has been introduced which is the Forward-looking TTC which would combine both PIT and TTC and provide an applicable model for CECL.

Because of the implementation of CECL would prove to be more intense in terms of verification of data, production and governance of models, and reporting patterns that were very much different in CCAR.

Although, CECL has its differences, which might prove to be challenging for banks to implement because of its extra need to store more data from tests and checks that are regularly performed, it has its own favorable implications that can change the face of calculating the allowance for loan losses too.