Loss discovery method of analysis for determining the correct method of loss
Loss Discovery measures the time between:
1. when an institution recognizes that a customer cannot meet his or her obligations, and
2. when a charge-off occurs.
Financial institutions may have thousands of customers, which can be difficult to manage. Consequently, performing commercial customers may only contact the institution once per year, typically during an annual review, and may not frequently submit financial information. Assuming once-annual contact, it could take an institution two years to identify that a borrower is on the verge of default. During this two-year period, the institution is incurring a risk of loss.
Consumer loans on the other hand may have a loss discovery period of as little as six months, since monthly payments would allow a financial institution to identify loss within a single year.
Loss discovery method mitigates risk by applying a factor to the historical and qualitative risk factors equal to the discovery period. Discovery periods vary across product types but may range from six months to two years. Assuming a two-year discovery period, the combined historical loss and qualitative rates would be multiplied by two before being multiplied against the pool balance. A six-month discovery period would multiply that combined rate by .5.
(Historical Loss Experience + Adjustments) X Loss Discovery Period X Loan Balance = FAS 5 Allowance Estimate
Developing discovery periods requires strong credit and loan administration teams to evaluate customer contact and its effect on recognizing default and loss, as well as analyze the Watchlist and credit review processes and their ability to discover additional risk. Teams will need to evaluate not just initial delinquencies but repeat delinquencies to uncover patterns. The frequency of covenants and their timely receipt should be considered as well.
For these reasons, along with the loss discovery method introducing more subjectivity into the allowance calculation and the process being more time intensive, most institutions steer away from this option for the determination of loss rate percentages.
To learn more about how to measure loss in the allowance, view our webinar on How to Determine the Right Measure of Loss.