Expected Credit Loss (ECL)

Older rules waited until a loss had been incurred before a provision was made. IFRS 9 replaced that with a forward-looking model, and the United States uses a related model called CECL. A lender estimates, for each exposure or group, the probability of default, the loss if default occurs and the amount owed at that time, then discounts the result. Under IFRS 9 loans fall into three stages. Stage 1 covers performing loans and carries a loss estimate for the next twelve months. Stage 2 applies when credit risk has risen significantly, and the allowance covers the whole remaining life. Stage 3 covers loans already impaired, also on a lifetime basis. Several economic scenarios are weighted, and managers often add overlays where models lag events. Judgment is heavy, so model risk and audit scrutiny are high. Banks watch it closely in downturns, when allowances jump ahead of actual defaults.

A bank holds 10,000 unsecured loans of 1,000 each. It estimates a 2% probability of default and a 60% loss if default occurs, giving an allowance of 12 per loan, or 120,000 in total. A forecast of rising unemployment lifts the default estimate to 3%. The allowance rises by half to 180,000 and reduces profit that quarter, even though no extra borrower has yet missed a payment.