From Incurred Loss to CECL: Historical Perspectives and Practical Guidance

Michel Araten

INTRODUCTION

In this chapter we will review how banks have historically set the allowance for loan and lease losses (ALLL) under the incurred loss approach (ILA) and how they are transitioning to the new current expected credit loss (CECL) model. We will begin by providing some background as to how accounting for reserves has evolved under accounting and regulatory concerns. We will then focus on the portion of reserves that deals with loans that have not yet defaulted and review the manner in which one major institution has developed the estimates for its key components. The importance and impact of the proper determination of reserves will be illustrated using two historical case studies experienced at one major financial institution. We will further explore how banks have regarded the ALLL as a key tool for stabilising and managing earnings. Finally, we will describe how banks are viewing the new CECL requirements and provide some guidance for fulfilling the requirements.

BACKGROUND

The recognition that credit assets on a bank’s balance sheet should not be carried at their full value, since losses may have been incurred but not yet realised, is a concept with a long histor

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