Bend Don’t Break
The economic impact of the current healthcare driven crisis is obvious when one looks at the most recent economic data. What isn’t obvious, however, is how the current crisis will impact loan losses for lenders, including CDFIs and community banks. We wanted to further explore a few ways that CDFIs and community banks could ensure their allowance model outputs accurately reflect the impact of the current economic situation.
But First…..Let’s State the Obvious
Before we explore a few possible solutions, we need to state the obvious: doing nothing is not an option. It is highly unlikely that any model data used as basis for determining an appropriate allowance has a loss history that mimics what the likely losses are over the next 6 to 12 months. Even institutions using more sophisticated models or models that have transitioned to the lifetime loss methodology would yield outputs that would be not be considered accurate.
Bending the Allowance Model
What can be done to give a lender flexibility in assessing the allowance needs? Here are three steps a lender can take:
Risk Rate Properly
- Ensure the risk rating of the entire portfolio is accurate, up to date and properly reflected on all internal systems. Given the breadth of the economic impact, it may not be possible to review each loan individually. Instead, lenders could consider applying risk rating changes en masse to groups of loans that share common characteristics. For example, consider loans made to the tourism industry. In the absence of specific information for an individual Borrower, consider a downgrade of these loans to a Watch category. This should trigger an increased level of review and an established time frame to either upgrade or downgrade the loan from the Watch category.
Utilize Existing Functionality
- Utilize existing flexibility in your quantitative methodology to create an output that accurately reflects incurred/expected losses. We consider this the most important step. You are not going outside of an approved model that has been vetted, documented and validated. Marathon runners have a saying: nothing new on race day. In other words, using this option doesn’t add any new or untested variables to the process.
Use Qualitative Adjustments
- Go outside your quantitative model and use qualitative assessments to determine the additional allowance need. However, these assessments should be based upon available data to support the adjustments. Existing accounting guidance (and the planned CECL methodology) allows for qualitative assessments as part of the allowance calculation. We advise lender assess how well the quantitative model captures a variety of characteristics (see SAB 119 guidance). Specifically for the current crisis, lenders would focus on the model’s ability to assess reserves relative to:
- Level and trends in delinquencies and impaired loans,
- Local and national economic trends,
- Effects of changes in prepayment expectations or other factors affecting assessments of loan contractual terms,
- Charge-off magnitude and volume and
- Industry conditions.
It is important to ensure the allowance for loan losses is calibrated properly. Setting aside sufficient reserves is something that investors, board members and regulators each want to verify. Taking these three steps will provided a broad-based assessment of the adequacy of the allowance for loan losses. Furthermore, the current crisis will bend but not break your ALLL assessment.