First there was Basel II, with it’s subsequent years of interpretation, model development, review, documentation, and refinement. In retrospect, it’s surprising how much effort went into estimating 12-month forward default rates under an average economy scenario. Then came stress testing: CCAR (Comprehensive Capital Analysis and Review) and DFAST (Dodd-Frank Act Stress Testing) required banks to look further into the future (9 quarters) under alternate economic scenarios. This is a fundamentally more challenging task than Basel II, because one must quantify and incorporate economic sensitivities, adjust for attrition / pay-off, and quantify not just the probability of default, but also the timing of default.
As always happens with new regulations, lenders and regulators both evolve their knowledge and expectations of what should be considered standard practice. For CCAR, lenders consistently report that the Federal Reserve examiners want the best possible models and at the loan-level. However, for the banks with assets less than $50 billion but greater than $10 billion that must only comply with DFAST, OCC and FDIC examiners are reported to have made comments such as, “If you build a more complex model, you will receive increased scrutiny.” Thus, the path of least resistance for banks is simple time series models, even though they fail to capture key portfolio dynamics and do not prepare banks for crossing the CCAR threshold.
Now we have CECL (the Financial Accounting Standards Board’s rules for Current Expected Credit Loss) and IFRS9 (the International Accounting Standards Board’s rules for International Financial Reporting Standards, latest revision), and both banks and examiners are groaning. Please, not another parallel model with different requirements and another cycle of interpretation, development, review, documentation, and refinement!
Although CECL and IFRS9 have some differences, both approaches require lifetime loss forecasting for loans of any age, considering current economic conditions but relaxing onto long-run averages beyond the foreseeable macroeconomic horizon. Although the regulations claim that any approach works so long as it pays homage to the original goals, CECL and IFRS9 modeling needs actually come closest to CCAR. Lenders of all sizes and business models, if they want models that are defendable to auditors and examiners, will need models with economic sensitivity, competing risks of attrition and default, and monthly or quarterly forecasting. The best models will be loan-level so that they consider current loan conditions and integrate with accounting systems.