A Holistic Model Validation Framework for Current Expected Credit Loss (CECL) Model Development and Implementation

Michael Jacobs
Additional contact information
Michael Jacobs: PNC Financial Services Group—Balance Sheet Analytics & Modeling/Model Development, 340 Madison Avenue, New York, NY 10022, USA

IJFS, 2020, vol. 8, issue 2, 1-36

Abstract: The Current Expected Credit Loss (CECL) revised accounting standard for credit loss provisioning is the most important change to United States (US) accounting standards in recent history. In this study, we survey and assess practices in the validation of models that support CECL, across dimensions of both model development and model implementation. On the development side, this entails the usual SR 11-7 aspects of model validation; however, highlighted in the CECL context is the impact of several key modeling assumptions upon loan loss provisions. We also consider the validation of CECL model implementation or execution elements, which assumes heightened focus in CECL given the financial reporting implications. As an example of CECL model development validation, we investigate a modeling framework that we believe to be very close to that being contemplated by institutions, which projects loan losses using time-series econometric models, for an aggregated “average” bank using Federal Deposit Insurance Corporation (FDIC) Call Report data. In this example, we assess the accuracy of 14 alternative CECL modeling approaches, and we further quantify the level of model risk using the principle of relative entropy . Apart from the illustration of several model validation issues and practices that are of particular relevance to CECL, the empirical analysis has some potentially profound policy and model risk management implications. Specifically, implementation of the CECL standard may lead to under-prediction of credit losses; furthermore, coupled with the assumption that we are at an end to the favorable phase of the credit cycle, this may be interpreted as evidence that the goal of mitigating the procyclicality in the provisioning process that motivated CECL may fail to materialize.

Keywords: accounting rule change; current expected credit loss; allowance for loan and lease losses; credit provisions; credit risk; financial crisis; model risk (search for similar items in EconPapers)
JEL-codes: F2 F3 F41 F42 G1 G2 G3 (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://www.mdpi.com/2227-7072/8/2/27/pdf (application/pdf)
https://www.mdpi.com/2227-7072/8/2/27/ (text/html)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:gam:jijfss:v:8:y:2020:i:2:p:27-:d:353344

Access Statistics for this article

IJFS is currently edited by Ms. Hannah Lu

More articles in IJFS from MDPI
Bibliographic data for series maintained by MDPI Indexing Manager ().