Credit Cards and CECL: What you need to know

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creditPotter (1).pngCredit cards are like Harry Potter. Hear me out. The Dursleys (Harry’s aunt and uncle) have a responsibility to raise Harry. But he’s...different than other kids, and the Dursleys don’t like that. In fact, they dislike it so much that they chuck him under the stairs and do their best to ignore him. Deep down, however, they know that Harry has the potential to cause them a lot of problems down the road when he starts to learn magic. 

Replace Harry with credit cards and the Dursleys with a financial institution facing CECL. In the CECL dialogue, credit cards (and other lines of credit) are often “chucked under the stairs” because they are fundamentally different than other asset classes, and it is uncomfortable to think of them in the CECL framework. Well let’s send those things an owl and pull them out of the woodwork (sorry, that was the last Harry Potter reference).
Seriously though, credit cards are tough! And here are some of the reasons:

 

  1. They rarely have a fixed term
  2. They are revolving
  3. They have unfunded commitments
  4. The balance fluctuates

So what is the right way to calculate an allowance for credit cards? Let’s turn to FASB. In the Accounting Standards Update (ASU) released in June of 2016, an example is provided of an institution applying credit losses to credit cards (Example 10). I’ve included the example here:

> > Example 10: Application of Expected Credit Losses to Unconditionally Cancellable Loan Commitments


326-20-55-54 This Example illustrates the application of the guidance in paragraph 326-20-30-11 for off-balance-sheet credit exposures that are unconditionally cancellable by the issuer.


326-20-55-55 Bank M has a significant credit card portfolio, including funded balances on existing cards and unfunded commitments (available credit) on credit cards. Bank M’s card holder agreements stipulate that the available credit may be unconditionally cancelled at any time.


326-20-55-56 When determining the allowance for credit losses, Bank M estimates the expected credit losses over the remaining lives of the funded credit card loans. Bank M does not record an allowance for unfunded commitments on the unfunded credit cards because it has the ability to unconditionally cancel the available lines of credit. Even though Bank M has had a past practice of
extending credit on credit cards before it has detected a borrower’s default event, it does not have a present contractual obligation to extend credit. Therefore, an allowance for unfunded commitments should not be established because credit risk on commitments that are unconditionally cancellable by the issuer are not considered to be a liability.

So, as long as unfunded commitments are unconditionally cancellable, institutions should only estimate losses on funded balances. For example, suppose credit card A has a current balance of $5,000, and a fortune teller informs us that the $5,000 will be paid off next month, but that sometime next year, the borrower will make new purchases on the card, which will subsequently default. For CECL, that future loss is irrelevant to the institution today because all $5,000 of the current balance will be collected.

How does this change the way we estimate expected losses? Well, because we are looking for the amount of the current balance that we don’t expect to collect, most loss rate methods become difficult. Sure, we can estimate expected future losses from the current pool of credit cards, but a portion of those future losses will be from currently unfunded commitments.

One possible solution is to use the Discounted Cash Flow with Probability of Default (DCF-PD) method, in which monthly probabilities of default and prepay are used to project expected cash flows for every future month in the life of the loan. Of course, because of the above discussion, the only future cash flows we’re interested in for credit cards are the cash flows related to the current balance. The manner in which the current balance pays down (if at all) will vary widely from loan to loan, so we have to make assumptions about how that will happen. A reasonably conservative approach would be to assume minimum payments on the current balance until it is paid in full. So, for each future month, potential cash flows (from minimum payments or payments in full) are weighted by their probabilities of occurring, and are discounted at the effective interest rate. The present value of future cash flows are then subtracted from current balance to arrive at expected credit loss.

Long story short, extra care should be taken for your lines of credit. Make sure your allowance truly reflects the amount of current balance expected to not be collected, and isn’t inflated by considering losses from unfunded commitments. That being said, don’t let lines of credit overwhelm you. There are ways of handling them. And if you ever find yourself truly weighed down because of CECL, remember that a wise wizard once said, “Happiness can be found even in the darkest of times, if one only remembers to turn on the light.”




Rachel Messick

Product Manager/Data Scientist at Visible Equity


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