January 16, 2019

ESRB published a report that examines the financial stability implications of differences between the expected credit loss approaches of EU and U.S. The report emphasizes that the extent to which the EU's expected credit loss (ECL) and the United States' current expected credit loss (CECL) models can anticipate a downturn is crucial for achieving their intended objectives. The report discusses the different features of the two standards and their intended and unintended consequences, along with the different business models and banking structures in Europe and in the United States.

The report argues that the ECL approach in IFRS 9 more accurately reflects the evolution of credit risk, as it follows the evolution of credit risk over time (with the importance attached to the concept of “significant increase in credit risk”) and limits the “double-counting” of expected credit losses at the initial recognition of a loan, which are already reflected in the interest rate applied (under the assumption that the price for credit risk is adequately set). However, the three-stage approach and the related requirements may introduce a certain degree of complexity in its practical application. CECL approach of the U.S., on the other hand, requires lifetime estimations of credit losses throughout the life of a loan and could be found to favor the practical implementation by reporting entities, even if it disregards the economic link between the pricing of a loan and its credit quality.

Furthermore, in terms of cyclical behavior, the existing limited academic studies show that the CECL approach may lead to higher impairment charges in normal times, while the ECL approach would have a larger impact at the onset of the crisis. Overall, the report concludes that the extent to which the differences between ECL and CECL approaches can impact financial stability by inducing changes in lending conditions is unknown at present.

 

Related Link: Report (PDF)

Keywords: Europe, EU, US, Banking, CECL, ECL, IFRS 9, Financial Stability, ESRB

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