Determining the right measure of loss
Chief financial officers at financial institutions have enough to worry about without the historical loss measure for FAS 5 loans. Unfortunately, key parties—from the Board of Directors to auditors to regulators—worry about it each time an ALLL calculation is performed. What measure is right? Does the loss period cover too much time? Does it go far enough? What about migration? Selecting a historical loss measure and then defending that measure may sound daunting, but it does not have to be a real challenge.
There are a number of methods used to measure expected loss for FAS 5 loans, and each has its own merit. Historical loss has been used extensively by financial institutions for years because the rates are easily determined and available in management and regulatory reporting. A more involved calculation, loss migration requires considerable resources but may be more accurate when measuring loss because of its granularity. Profit Default/Loss Given Default builds on the default probabilities already built into an institution’s risk rating process by incorporating industry- or segment-specific loss percentages to calculate expected loss.
Loss Discovery Period is a variant of all three that adds a new factor, which is the time between:
- when an institution recognizes a customer cannot meet his or her obligations and
- when a charge-off occurs.
Selecting the correct period requires an analysis of the portfolio’s past, not just recent performance. This includes an evaluation of the performance and loss history for each line of business as well as changes in credit policies, portfolio volume and management over time.
This is not an exercise that can be done in a vacuum. One size (or loss discovery period) does not fit all. Selecting the loss measure is an opportunity to engage professionals from across the institution and build consensus on a loss measure as well as common or unique loss horizons for each segment. Having that consensus, along with quantifiable research and documentation, lends credibility to the selected measure when defending it to stakeholders.
To learn more about how to measure loss in the allowance, view our webinar on How to Determine the Right Measure of Loss.