Current expected credit loss procyclicality: it depends on the model

Joseph L. Breeden and Maxim Vaskouski

Abstract

The new guidelines for loan loss reserves, current expected credit loss (CECL), were initially proposed so that lenders’ loss reserves would be forward-looking. Some recent studies have suggested that CECL could be procyclical, meaning that loss reserves would peak at the peak of a crisis. Although it is better than seeing failure only after it has happened, being required to raise liquidity at the peak of a crisis could still fail to save the lender from collapse, and it may even facilitate the latter. However, previous procyclicality studies have explained all losses using macro- economic factors, ignoring the changes in credit risk and other portfolio drivers that preceded the recession. The current work looks at a wide range of models to test the degree to which CECL is procyclical for different types of model. The tests were also run using real historical macroeconomic scenarios, flat scenarios or mean-reverting scenarios. All tests were conducted on publicly available data from Fannie Mae and Freddie Mac using publicly disclosed models. Our study found that CECL lifetime loss estimates were only marginally sensitive to the quality of the economic scenario but changed dramatically with different modeling techniques. Some methods predicted increased loss reserve requirements as early as 2006, while others only saw the recession as it happened or even afterward. Therefore, procyclicality under CECL will be strongly influenced by the choices of the lender.