CECL: Timely Loan Loss Provisioning and Banking Regulation

We investigate how loan loss models affect banking regulation. We study an incurred loss model (IL) and a current expected credit loss model (CECL). Relative to IL, CECL improves efficiency as it allows for timely intervention to curb inefficient ex post asset-substitution. However, from a real effects perspective, our analysis uncovers a potential cost of CECL: banks respond to timely intervention by originating riskier loans so that timely intervention induces timelier risk-taking. By appropriately tailoring regulatory capital to information about credit losses, the regulator can improve the efficiency of CECL. In particular, we show that regulatory capital under CECL would be looser when early estimates of credit losses are sufficiently precise and/or asset-substitution incentives are not too severe. From a policy perspective, our model therefore calls for better coordination between banking regulators and accounting standard setters.