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CECL’s “Life of a Loan” Explained

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Collaborating author: Tracy Abruzzo

Our CECL blog series has covered topics large and small. Today we take a step back and review one of the CECL “basics.” Many have heard that the CECL model emphasizes the need to recognize “expected” credit losses in contrast to the current “incurred” loss approach.  

What does it mean to estimate the expected credit losses over the contractual life of the loan?   

CECL’s concept of expected credit loss includes the use of forecasted information over some future period. The expected life of the asset drives the reserving levels more than any other single variable in the CECL world -  the life of the instrument will be even more significant than it is today. 

Does the FASB expect institutions to estimate credit losses over the contractual or expected life of the loan?

FASB does not expect financial institutions to estimate credit losses over the entire contractual life of the loan. Institutions may consider the behavioral life (also referred to as the expected life) of the loan, which includes the effects of future events such as prepayments. Considering behavioral life of loan will be especially important for longer-dated loans such as mortgages.

CECL also caps the period over which a credit loss is analyzed at the contractual duration of the instrument. Even if an expected credit loss could be economically incurred after the instrument’s contractual life, the CECL model will not include that expected credit loss unless a Troubled Debt Restructuring (TDR) is reasonably expected to occur that would extend the contractual maturity of the instrument.

For the future periods beyond which an entity can make reasonable and supportable forecasts of expected credit losses, the entity should revert to historical loss information. 

The bottom line

The period over which an expected credit loss is analyzed is limited to the shorter of the full contractual life or its reduced “expected life version” based on forecasted prepayments (unless a TDR is expected). 

 

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About Author

Keith St. Germain
Keith St. Germain

Keith St. Germain is a Director at CrossCountry Consulting. Keith has over 13 years of consulting experience, focusing on performance improvement within the Financial Services industry. This includes finance transformation, business process re-design, organizational and target operating model assessments, organizational change management and regulatory requirement responses. Click here to read Keith's full bio.

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