With increased scrutiny surrounding a financial institution’s ALLL calculation, many are asking how they improve their process and make it more comprehensive. Of course there isn’t any one answer to this question, and the direction can vary based on an institution’s starting point.
A segmentation strategy, though, is a great place to start to nail down an effective and efficient process – not only will it serve a substantial purpose for the ALLL, but also as a larger risk management tool. The ability to adequately meet ALLL, stress testing, and other risk management requirements relies upon sound segmentation practices.
For nearly any size institution with lending capabilities, a comprehensive loan portfolio segmentation strategy can enable their credit department to quickly identify the underlying behaviors that drive credit risk. To best understand that risk, bankers look at segments of the portfolio to monitor performance over time. Using segments, an institution can not only evaluate the causes driving a loss, but also then adjust underwriting strategies, such as adjusting pricing or setting lower lending limits, within the segment to mitigate further loss such. By digging further into segments, the bank can better understand the average loss-emergence period.
Proper risk identification focuses on recognizing and understanding existing risks or risks that may arise from new business initiatives. Typically this identification is assessed during the underwriting process and then again during annual reviews. Borrowers in a segment generally exhibit similar financial characteristics such as capital sources and/or repayment sources. Identifying the commonalities allows an institution to look for big-picture risks before diving into individual loan losses.