The ALLL today – quantitative challenges
With the 2016 release of the Financial Accounting Standards Board’s (FASB) guidance on the CECL model, banking professionals and consultants have been theorizing about the impact the standard will have on current bank processes. While it is important for these banking professionals to be prepared, consultants are stressing the importance of tackling today’s allowance challenges too.
One of the challenges impacting financial institutions under current GAAP is how they choose the loss rate methodologies to apply. While data gathering and management are critical steps in the preparation process for CECL, it is important to understand the data and adjust the methodology to maintain accurate loss rates.
“Choosing and applying the “right” loss rate method is possibly the biggest challenge for most institution’s ALLL today,” said Sageworks Director of Consulting Aaron Lenhart. “Loss rate methods matter, but are mostly driven by charge-offs and the recoveries continue to outpace charge-offs in many situations.”
Common Quantitative Challenges:
- – Loss rates are driven by charge-offs
- – Low loss environment good for banking, not as good for ALLL models
- – Look-back periods can only be stretched so far with the effect of older losses being diluted by longer period averages
- – Many institutions seeing negative loss rates pushing the recoveries to frequently outpace the charge-offs
Options to bolster loss rates include
- – Extending look-back periods
- – Period specific weightings – To mitigate risk here, institutions can add pre-emergence period added to calculation for LEP
- – Loss emergence periods
- – Introduce loss rate floors
Charge-off based models may understate required reserves during a turn in the business cycle – to a greater extent under CECL.