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How Segmentation Can Benefit a Bank’s ALLL and Risk Management Practices

July 1, 2015
Read Time: 0 min

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.

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Given the importance segmentation has in risk identification, just how much should an institution segment ASC 450-20 (FAS 5) pools?

There isn’t really a clear-cut answer. There is no “one size fits all” segmentation strategy. The number of pools is best decided by the individual institution, depending on factors such as portfolio composition, volume, homogeneity within pools or risk levels.

Current guidance suggests the loan portfolio should be broken down into homogenous pools based on similar attributes, and FDIC call code segmentation is likely a good starting point for many institutions. The goal is for the segmentation to be granular enough for the pools to show those similar loan characteristics. One common example is breaking down an institution’s residential or even commercial real estate lending segments into those that are owner-occupied versus those that are non-owner occupied.

Of course, there’s some risk to segmenting the pools and making them too granular. With many smaller pools, the loan balances within each pool can become too small to easily identify trends and potential risk. Not only will that become too cumbersome, but too much granularity may sacrifice the statistical significance of the calculation.

Given the scrutiny around the ALLL, it’s important to find a sweet spot of segmentation for each bank or credit union’s unique loan portfolio. Evaluating that spot of granular pools without sacrificing quality will save an institution from headaches surrounding their ALLL and risk management practices during exams.

About the Author


Raleigh, N.C.-based Sageworks, a leading provider of lending, credit risk, and portfolio risk software that enables banks and credit unions to efficiently grow and improve the borrower experience, was founded in 1998. Using its platform, Sageworks analyzed over 11.5 million loans, aggregated the corresponding loan data, and created the largest

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