How would you spend 2 free weeks?
A noticeable trend in banking, whether at the request of examiners or in the pursuit of efficiency, is additional automation in credit-risk management processes. Often, automation results in significant time savings and further granularity with reporting. How would you spend the new, free time?
Let’s consider one process in particular: the allowance for loan and lease losses (ALLL). If an institution does automate data collection and the calculation, what’s the best way to spend the (up to) 2 weeks saved through automation each quarter?
Most likely, all of us have ways we would like to spend the 2 weeks….but in the name of risk management and better understanding the institution’s portfolio, here are some recommended ways to use gained time to also gain portfolio and policy insight.
Many of these examples can also be part of the automation process, so work required is minimal and involves reviewing reports that can be generated automatically through an ad-hoc reporting system.
1. Assessing risk in FAS 5 pools of the ALLL. FAS 5 pools are generally evaluated to determine loss rates, but when time permits, analysis can extend to cover delinquency, charge offs, non-accruals, rating changes and balance trends at the FAS 5 pool level. These results provide quantifiable support for qualitative factor adjustments, an area of the calculation that bankers recognize receives scrutiny.
2. Monitoring pools over time. Access to FAS 5 pool data means the bank is also equipped to monitor the health of individual pools over time, while most institutions focus reporting on the broader portfolio. As an example, one bank looks at the 12-month trend in each pool using graphical representations to more easily identify issues that may be arising. Those trends can be included in documentation as further support for assumptions in the calculation or rationale for certain decisions.
3. Testing different calculations. If afforded extra time, bank management can also create different calculations for testing new methodologies or what-if scenarios for assessing their impact on the allowance provision. For example, an institution can see how the reserve would be impacted if there was an economic crisis and qualitative factor adjustments had to significantly change. Or, how would the results differ if the institution used a 12-quarter lookback window instead of 8 quarters? What if the bank was trying migration analysis for the first time; how would that compare to their current methodology using historical loss rates? The different scenarios may or may not be used in the final calculation, but it arms bank management with greater intelligibility on proposed changes and opportunities for managing the allowance.
4. Backtesting the methodology. When a bank isn’t scrambling to finish the ALLL and instead has time for analysis, part of the analysis should also extend to the ALLL methodology itself by backtesting calculated results and making adjustments to the methodology when appropriate.
Greater analysis promotes a greater understanding of the calculation’s components and the appropriateness of each of those estimated components. This analysis also provides management with insight into areas of potential loss exposure and credit risk so management is equipped to manage those areas.
In a nutshell – although merely completing the calculation may satisfy regulatory requirements, it’s in the analysis of that calculation that management is able to identify exposure and formulate a plan to mitigate it.
Find out more about backtesting and validating your ALLL methodology in this whitepaper Backtesting: Measuring the Effectiveness of ALLL Methodologies.