You aren’t prepared for 2015 if your ALLL lacks these traits
In preparing for the allowance for loan and lease losses (ALLL) calculation in 2015, bankers have a lot on their plates. The ALLL has received significantly more attention in the past few years, and the trend of examiner scrutiny does not appear to be letting up. If anything, regulatory bodies will be focusing even more on the allowance calculation in 2015 as institutions switch from an incurred loss model to an expected loss model.
That said, if institutions are heedful of certain process improvements and incorporate them into their methodologies, they will be in a more defensible position when the examiners come knocking. In particular, institutions should focus on a few overarching principles to strengthen their calculations. These consist of:
A more comprehensive calculation will yield more accurate results and a more sound methodology as a whole. One example of how an institution can arrive at a more comprehensive calculation is to implement more robust forms of analysis. For instance, if an institution is in de novo status and has built up a substantive pool of data, graduating to a historical loss methodology will make its ALLL more comprehensive than using peer analysis. In most cases, banks and credit unions use a historical loss methodology, so moving to PD/LGD or migration analysis would result in a more comprehensive calculation.
Defensibility comes down to data and proper support for your assumptions. Your calculation must be reliable and consistently applied in order to increase defensibility. Institutions can improve this component of their calculation by archiving loan-level data for more granular segmentation and pooling analysis, creating a qualitative scoring matrix to ensure directional consistency, backtesting to confirm reliability and having their model validated on an annual basis as suggested by 2006 interagency guidance.
Flexibility refers to your institution’s ability to appropriately adjust your methodology as is necessary. This does not mean that your aim is to be inconsistent; rather, having flexibility means that you can adapt and evolve as the needs of the ALLL change. Scenario building is a large part of having flexibility. If your institution practices scenario building, you can explore a range of possibilities and make informed decisions based upon your findings, not to mention you can bolster your environmental risk factor documentation with results of scenario tests. A few examples of this may include: What would my reserve level be if I switched to migration analysis? How much do I need to provision if a particular segment of my portfolio underperformed? If I changed my look-back period, what would it do to my overall reserve levels? How will the transition to an expected loss model impact my capital levels? Knowing these answers before taking action can be invaluable as banks strategically plan for the future of their ALLL.
Institutions with a very transparent and auditable allowance calculation tend to do far better in exams. Just as your 4th grade teacher mandated you show your work when you did long division, examiners will do the same for the allowance calculation. It’s not enough that YOU know why you incorporated an unallocated reserve this quarter – examiners must be able to see each and every step in your calculation. Ways to improve auditability include incorporating workflow processes and approval processes into the methodology, bolstering your reporting capabilities and using a system that allows read-only access so examiners can step into your shoes and see exactly what’s been done. Exams, at times, can be a game of momentum. If you provide all the documentation and your presentation is sound, examiners are more bought in to your methodology. Conversely, if you fail to properly document one portion of your calculation, you can expect every portion examined henceforth to be more heavily scrutinized.
When polled recently about their biggest concern surrounding these factors during a webinar on strategic planning, bankers’ responses were fairly evenly distributed. This is a testament to the importance and relevance of all four principles.
As your institution deliberates and plans for the future of the allowance calculation, be mindful that adherence to these four measures is in your discussions. If you are interested in a more granular discussion of how to indoctrinate these principles into your ALLL process, feel free to download our related whitepaper, “Three Ways to Prepare for Year-End.”