Financial reporting standards require banks to use not just historical data but also forward-looking information when estimating credit losses. MEVs provide that forward-looking lens.
Under financial reporting standards, ECL are provisions set aside for possible defaults. There are different levels of ECL. ECL 1 is a provision for possible default within the next 12 months, even if the borrower looks healthy. For ECL 2, the bank must set aside provisions for the probability of default (PD) over the entire remaining life of the loan, not just the next year.
ECL 3 is when the borrower has already defaulted. This means they have stopped paying back the loan. At this point, the bank assumes the worst and sets aside provisions for the full expected loss.
Individual banks have different MEV models due to differences, including geography and risk-free rates. MEVs influence the 12-month PD for ECL 1. For example, if forecasts show an economic slowdown, banks increase provisions even for healthy loans.
For ECL 2, MEVs are critical because provisions are based on lifetime PD. A worsening macro outlook (for example, recession forecast) can push loans from ECL 1 to ECL 2, requiring larger provisions to be put aside. Although defaults are already recognised when loans are classified as ECL 3, MEVs still matter for recovery rates. For instance, falling property prices reduce collateral values, increasing expected losses. However, when they rebound, parts of the loan could be written back.
