Top benefits of ALLL scenario building
Though it may be often overlooked, scenario planning allows bankers to assess the outcome of the ALLL calculation under various assumptions or “scenarios.” Bankers can then estimate the impact that ALLL-calculation variables may have on the final reserve without having to perform a completely new calculation. The process can be challenging, especially for institutions that use spreadsheets to perform the calculation; however, the strategic advantages gained from scenario building often outweigh any difficulties implementing the process.
Here are two common components of the ALLL calculation for which banks can implement scenario building:
Capital Planning for CECL
One benefit that comes with scenario planning is increased preparedness for the FASB’s CECL model. This proposed model will require banks to consider expected rather than incurred losses as required by today’s guidance. In a February 2014 survey conducted by Sageworks, 50 percent of more than 500 banking professionals believed the proposal would increase reserves between 10 and 50 percent.
It is expected that once the new guidance is in effect, an institution would need to record a one-time capital adjustment to account for the new methodology. While there are no immediate steps required, institutions can proactively review processes, methods and balances now to assess whether they are flexible enough to account for these and other future changes. Scenario planning could show the worst-case scenario(s) and help answer questions like:
• If the new model requires a 30 percent increase to the ALLL, how does that affect my Tier 1 ratio?
• How much of an increase to the ALLL can my bank handle without having capital adequacy issues?
Altering Look-Back Period
Scenario planning also allows a bank to examine the impact of using different look-back periods. For example, a bank may use a four-quarter look-back period. But when the bank changes this window to eight quarters, it may find its ending average loss rate to be drastically different.
Aside from changing the length of the period, institutions can also build scenarios by weighting certain periods or using different time periods (annual, quarterly or even monthly loss rates). For instance, those with drastically decreasing or increasing portfolios may find a material difference and benefit from a more granular view when switching from a two-year to a 24-month look-back period.
Twelve quarters may be most appropriate for one bank, but recent quarters may be more indicative of the current economy. An appropriate scenario to test, then, would be to weight the most recent four quarters at 40 percent while weighting 60 percent across the remaining eight.
Adjusting, or at least testing, look-back windows can be a very timely exercise for banks, especially now when many are trying to maintain their ALLL levels despite periods of low loss. In this instance, institutions may wish to examine alternate scenarios, including different look-back windows, to ensure their ALLL levels are reflective of probable and estimable credit losses.
The advantages of scenario planning certainly extend beyond the two examples mentioned above. Additional benefits can be found in this complimentary whitepaper: Four Advantages of ALLL Scenario Building.