When Should a Bank Start Using Migration Analysis?
Migration analysis is a rigorous analytical process recommended by the regulatory agencies to determine financial institutions’ allowance for loan and lease losses or the allowance for credit losses under the current expected credit loss standard, or CECL. However, migration analysis is often underutilized in lieu of other processes that are perceived to be easier.
Migration analysis for determining loss rates
The purpose of migration analysis is to determine what rate of loss an institution has incurred on similarly impaired or past due loans. Typically under the incurred loss method of estimating credit losses, financial institutions that have a loan portfolio between $400-500 million should consider using migration analysis. There needs to be a large enough number of loans in the portfolio to make migration analysis work. Migration analysis not only requires segmenting your FAS 5 portfolio, but also requires sub-segmenting over time, for example into special mentions, substandard or doubtful. If you have a loan portfolio smaller than $500 million, the sample might be too small, leading to anomalies in the statistical analysis of each sub-segment. That would make migration analysis less effective.
Using migration analysis under CECL
Migration analysis, also known as a “Closed Cohort Migration to Loss” analysis, under CECL has sub-segmentation calculations for ordinal risk characteristics (times delinquent, risk rating, ordinal risk descriptor). This methodology both describes a life-of-loan number and can accurately price the additional risk for deteriorated loans. Typically, “Pass” credits will remain with low reserve and immediately receive additional allocation on migration through the risk levels.
Migration analysis is typically recommended for shorter lived pools (less than three years) that have risk diversity and reconciled controls around that risk diversity. It is typically sensible for renewing commercial credits. Migration analysis may not be recommended for pools with insufficient loss history, long-lived pools, or pools with no risk monitoring.
Additional information on migration analysis
To see a migration analysis example and learn more, read our whitepaper on the pros and cons of migration analysis and other CECL methodologies.
For help enhancing your current allowance processes, testing potential alternate CECL approaches, or adopting single or multiple methodologies, learn more about Abrigo’s Advisory Services.