What’s The Same – And What’s Not – In Assessing Credit Quality

assessment-7-30-18.pngSince the 1970s, there has been an inevitable march toward a macro, quantitative assessment of credit quality. Technology and big data ensured its emergence to complement the more traditional, transactional counterpart of credit risk management.

Since the adoption of the 2006 allowance for loan and lease losses (ALLL) guidance, and the ferocity of loan losses during the great recession, we have seen the growing confluence among credit, accounting, regulatory and investor constituencies attempting to answer the same age-old questions: How much loss is embedded in the loan portfolio? How much is this portfolio worth?

While having comparable goals, each level of management has its priorities, biases and specialized methodologies for answering those questions. For directors, there may be a need to connect the dots to determine the objective of these measures.

Today’s ALLL
The current loss methodology was also used in 2006, prior to the massive, mainly real estate, credit losses from the great recession. The 2006 methodology included pool, formula-driven and specific impairment loss estimates. The incurred loss bias of the current methodology–often known as a “run-rate” approach–inflates the most recent credit quality performances. With no significant losses prior to the crisis, the industry was largely pushed into the abyss with low loss reserves–unable to raise reserves for forecasted losses. Given the relatively benign state of credit currently, it could be said that we are back to the future, having to defend ALLL levels, largely with qualitative justifications.

Tomorrow’s CECL
The soon-to-be implemented current expected credit loss (CECL) methodology is the inevitable reaction to the roller coaster nature of today’s ALLL. Some even consider it a fall back to the failed bid, about eight years ago, to impose mark-to-market valuations on the entirety of banks’ loan portfolios. Regardless of the pejorative “crystal ball” moniker often describing CECL–not to mention estimates of significant Day One implementation increases in reserves–its integration of historical losses, current conditions and reasonable forecasts is designed to be the more holistic, life-of-loan estimation of losses.

There is a high presumption in CECL that quantitative measures, such as discounted cash flows or probabilities of default (PDs)/loss given defaults (LGDs), overlaid by recovery lags, will be used to project future losses. In theory, it may be a more reliable estimate than the current guidance; however, its greatest hindrance is the perception that it is yet another de facto variant layer of capital buffer mandated by the Dodd-Frank Act, and Basel III.

Exit Price Notion
This accounting-based fair value measure disclosure (ASU 2016-01), often referred to as fair value/exit pricing, is new for 2018 and specifies the method by which public financial institutions calculate the fair value of their loan portfolios for purposes of disclosure. Fair value is the amount that would be received to sell an asset or paid to transfer a liability at the measure date. The estimate of fair value must be supported through specified protocols of valuation and calculation. Credit-based assessments, coupled with ties to loan review and risk grade migrations, will be key to justifying a reasonable, point-in-time fair value calculation.

Credit Mark in Mergers & Acquisitions (M&A)
Speaking of fair value, in M&A, it is truly in the eye of the beholder. How skeptical is the buyer? How much does the buyer want the deal? Determining a credit mark, or rational estimate (or range) of discounts to be applied to a prospective purchased loan portfolio, is very much a credit-based, symbiotic marriage between a traditional, more qualitative loan review and the more quantitative metrics of PDs, LGDs, risk grade migrations, yield marks, recovery lags and probabilistic modeling. Using one approach, without the informing nature of the other, is problematic and increases inaccuracies. What is sacrosanct in credit mark, is that an institution never wants to undershoot the estimates. Accounting plays a greater role when the deal-negotiated credit mark is refreshed at the deal’s completion, known as Day One accounting.

The credit discipline has often described as a qualitative decision stacked on an array of quantitative metrics. That remains an apt description for transactional credit–where it all begins. However, the new frontier in managing credit risk, even at smaller financial institutions, is in the ever-evolving, mostly mandated, macro, quantitative measures–some of which are described above. Each of these, not unlike a Venn diagram, has similarities and overlapping portions, but each has separate purposes, as well. Directors, like credit officers, need to understand and embrace these quantitative measures, which will, in turn, lead to better decision making for the bank.

Back to the Future: The Allowance for Loan and Lease Losses

5-18-15-CRM.pngOne of the most important figures on a bank’s balance sheet is the allowance for loan and lease losses (ALLL), as it provides an estimate for future credit losses. More than a decade ago, the “unallocated” ALLL was the subjective component of the allowance, which was often criticized for being poorly supported. Regulatory guidance issued in December of 2006 attempted to provide a framework to support this portion of the reserve through the use of a Qualitative & Environmental (Q&E) adjustment. However, the financial crisis soon hit and the resultant high historical loss rates lessened the impact of the Q&E adjustment. Now, we are “back to the future;” the industry-wide ALLL was 1.5 percent at the end of 2014 while annual charge-off rates accounted for only one-third of that total. As the Q&E component of the ALLL has grown, the scrutiny over the Q&E from regulators and external auditors has increased proportionately.

Today’s primary regulatory guidance on ALLL is the December 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses. In the section covering the general reserve (Formerly FAS 5, now ASC 450-20), it indicates that while historical loss experience provides a reasonable starting point for the institution’s analysis, management “should consider” those qualitative or environmental factors that are likely to cause the estimated credit losses to differ from historical loss experience. Nine factors are listed and are summarized as 1) lending policies and procedures, 2) economic conditions, 3) nature/volume of portfolio, 4) lending/credit staffing, 5) asset quality, 6) loan review system, 7) collateral valuation, 8) loan concentrations, and 9) other external factors.

Balanced Approach
Q&E methodologies used today range from formulaic approaches to subjective determinations. The regulatory guidance suggests that “management must exercise significant judgment when evaluating the effect of qualitative factors on the amount of the ALLL.”  However, at the subjective end of the spectrum, we begin to resemble the old “unallocated reserve” method which is frequently criticized in today’s Q&E world. Community banks may want to consider a balanced approach, which can be accomplished in five simple steps.

  1. Factor Selection
    This one is easy. Use the nine factors listed in the interagency guidance. You are free to select additional factors if it is relevant to your portfolio, but you should not ignore any of the nine factors.
  2. Data Gathering
    For each of the nine factors, gather the appropriate data. The data should include not only current data, but also trend data that covers a considerable period of time and certainly spans the historical loss period utilized in calculation of the bank’s historical loss rates. Provide data in graph form whenever possible as it facilitates the review and analysis process. Data can come from a variety of sources including the government (federal, state and local), other publicly available data sources, as well as bank and bank peer group data.
  3. Factor Analysis
    The information gathered for each of the nine factors should be analyzed and summarized with an overall assessment of how this factor has changed from the periods covered by the historical loss rates to current conditions. It is also helpful to identify specific loan segments within the portfolio that may deviate positively or negatively from the overall assessment. The overall assessment can be summarized by a letter grade or rating on a numeric scale but other approaches to capturing an overall assessment may be preferable, depending on circumstances.
  4. Q&E Adjustment Setting
    The critical decision is how to best translate the nine-factor assessment into a basis point adjustment for each of the loan categories. One approach is to develop certain adjustment scales for each of the nine factors to be applied to each loan segment. A less formulaic approach would combine the nine-factor assessment with quantitative information regarding each loan segment, such as 1) unadjusted loss rate, 2) historical loss rates for bank and peer group over different time horizons, and 3) sensitivity loss rates informed by adverse case scenarios. This holistic approach would allow management to determine the overall effect of the Q&E factors for each loan segment while being informed by quantified impacts under differing scenarios.
  5. Trend Analysis
    This step is often overlooked as management is just glad to have finished the Q&E adjustment process. The interagency guidance indicates that documentation should include management’s analysis of how each factor has changed over time.  A summary table that captures the trends in the nine-factor assessment and compares it with the trends in the Q&E adjustment by loan category, along with a narrative, could serve as documented support for the directional consistency of the adjustments with the underlying trend information.

While it may seem like a “back to the future,” approach, properly assessing your bank’s Q&E can be accomplished through a structured, consistent, and well-informed method that doesn’t involve rocket science.

The FASB’s Proposal on Credit Losses: What’s the Status?

8-30-13-Crowe.pngTrying to make improvements to the accounting for the allowance for loan and lease losses (ALLL) has been an endeavor for standard-setters for many years.

Because ALLL is the most significant estimate on the balance sheet for most, if not all banks, any changes to the accounting for credit losses is particularly important to the financial institutions industry.

Before the most recent proposals, the American Institute of Certified Public Accountants (AICPA) had taken up the cause and issued a proposal in June 2003, but based on the feedback received, that project did not move forward.

Motivated by the credit crisis, the Financial Accounting Standards Board (FASB) formally took on the project and issued a comprehensive proposal in May 2010. The proposal would apply to all banks, both public and private, and introduces a new model that is widely thought to result in an increase the amount of the ALLL.

The proposal was largely thought of as the “fair value proposal,” but it also addressed credit losses. At the same time, the International Accounting Standards Board (IASB) also was seeking to make improvements to its credit losses guidance. After hearing from their constituencies a desire to have a converged solution, the two boards sought to work together to require more timely recognition of credit losses and additional transparency about exposure to credit risk.

The first attempt was a proposal issued in January 2011. The proposal received mixed reviews, so the boards decided to explore alternative models. The boards jointly developed a “three-bucket” approach in which an allowance would be established by capturing three different phases of deterioration in credit quality. After hearing numerous concerns about how understandable, operable, and auditable the model would be, the FASB chose an alternative model known as the “current expected credit loss” (CECL) model, which was issued as a proposal, “Financial Instruments – Credit Losses (Subtopic 825-15),” on Dec. 20, 2012.

The CECL model considers more forward-looking information than is permitted under current U.S. generally accepted accounting principles (GAAP). Under the CECL model, the estimate for credit losses would be based on relevant information about past events, current conditions, and reasonable and supportable forecasts. Simply stated, this requires “life of the loan” estimates and recording of day one losses. Under GAAP, losses are not recorded until it is probable that an asset is impaired or a loss has been incurred. In addition to covering loans, the proposal also addresses debt securities, so the current other than temporary impairment (OTTI) model would be replaced.

Comments on the CECL model were due April 30, 2013, and the FASB received more than 360 letters. The FASB also performed additional outreach to approximately 70 analysts to understand whether the proposal would improve financial reporting for users and conducted 17 field visits with preparers to understand the cost of application and operational considerations.

The FASB found that users’ views differ significantly from preparers’ views. By a margin of nearly three to one, users prefer a model that recognizes all expected credit losses. In contrast, most preparers prefer a model that either recognizes only some of the expected credit losses or maintains a threshold that must be met before all expected credit losses can be recognized. Not surprisingly, financial institutions raised significant concerns about the potential impact of the model on regulatory capital.

The FASB learned that many preparers are under the impression that management would be expected to forecast economic conditions over the remaining life of the assets – which was not the FASB’s intent. Upon comprehending the FASB’s expectations about estimating expected credit losses, nearly all preparers indicated that the measurement of lifetime expected credit losses would be operational. However, the preparers cited the incremental costs and effort of moving to a “life of loan” expected credit loss model and reiterated a preference for a model that either recognizes only some of the expected credit losses or maintains a threshold that must be met before all expected credit losses are recognized.

Meanwhile, the IASB proceeded with issuing its proposal, “Financial Instruments: Expected Credit Losses,” on March 7. The proposal retains the tenets of the “three-bucket approach” but now refers to it as the “three-stage approach.” The comment period ended July 5.

On July 23, the two boards discussed feedback received on their respective proposals. The meeting was informational, and no decisions were made. Based on the outreach performed, each board found support for its respective models: the IASB from both users and preparers and the FASB from users. Russell Golden, the chair of the FASB, suggested a next step to convene the users that both boards engaged in order to try to reconcile the competing views. Stay tuned – it will be interesting to see if the boards can come together with a converged solution.

Read the Crowe Horwath LLP article, “Is the Third Time the Charm? The FASB Proposes Major Changes for Credit Losses,” for a more in-depth discussion of the proposal.