Early view of CECL integration into stress testing: practical approaches

Ken Carson and Francisco Covas

This chapter will analyse several important challenges to the integration of the current expected credit loss (CECL) standard into stress testing. First, we calculate the size of the increase in allowance for loan and lease losses (ALLL) and the common equity Tier 1 (CET1) capital ratio due to the perfect-foresight assumption for a representative bank. We then discuss a few approaches that can be applied to offset the increase in capital requirements. Under CECL, the calculation of loan loss allowances depends significantly on forecasts of the business cycle over a medium-run horizon. As a bank goes through each period of the stress scenario horizon, it needs to generate a new baseline macroeconomic scenario to calculate CECL-based allowances. In practice, the requirement to generate a new baseline macroeconomic scenario increases the complexity and subjectivity of stress testing.

The assumption of perfect foresight circumvents the need to develop a new baseline scenario in each period of the planning horizon since, under this assumption, we know exactly how the future will unfold. However, the assumption of perfect foresight increases capital depletion under stress, as banks