Managing Cost, Efficiency & Control in the Loan Portfolio

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What sets today’s lending environment apart is the potential for banks to collaborate with technology platforms to manage their risk more effectively and efficiently, explains Garrett Smith, the CEO of Community Capital Technology. In this video, he outlines how banks of varying sizes are diversifying their loan portfolios, and he shares his advice for banks seeking to buy or sell loans on the secondary market.

  • Using Technology to Manage the Loan Portfolio
  • Purchasing Loans on a Marketplace Platform
  • What to Know About Selling Loans

The Secret To Mortgage Lending To First-Time Buyers

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mortgage-2-11-19.pngMarket volatility and interest rate hikes have created uncertainty for the entire mortgage industry. Lending portfolio growth has also met pressure from the tight housing supply and the influence of fintech on the mortgage process.
One bright spot in the coming years will undoubtedly be the first-time homebuyer market, but banks must adapt traditional lending practices to capitalize and compete successfully.

First-time home purchasers are now 33 percent of potential buyers. Some surveys have indicated millennials–the largest future housing buyer population–are starting to embrace home ownership. Crafting effective loan options for this demographic can provide opportunity for mortgage and home equity portfolio growth, achieve consumers’ home ownership goals and deliver beneficial partnerships between banks and borrowers for years.

Banks must address the following concerns with the first-time buyer:

  • Affordability: They are more likely to seek popular urban and so-called “surban” (new or redeveloped areas with an urban feel) environments to live. Today’s first-time buyers are enticed by alternative housing choices that typically have higher-priced entry points. Traditional builders have not focused on this sector due to profitability pressures from increased labor and materials costs, leading to a limited supply of entry-level housing. Rising interest rates further stress affordability factors for the first-time buyer and limit the options available for mortgage funding. 
  • Debt and Lack of Savings: More than 50 percent of millennials carry a rising amount of debt, with the average 2016 graduate holding more than $37,000 in student loans compared to $18,000 for the average 2003 graduate, according to Forbes. The pressure of this debt load means would-be buyers have little or no savings available for the traditional 20 percent down payment. Rate increases, especially on adjustable student loans, can exacerbate this issue for the first-time buyer though Redfin predicts a competitive labor market should bring higher wages in 2019.
  • Income and Alternative Purchase Structures: The rise of the “gig economy” has led to a high number of independent contractors in this cohort, according to Forbes. Emerging first-time buyers have also shown interest in purchasing homes to create opportunities for rental income and nontraditional co-borrowers.

Lenders can differentiate their approval process from competitors by empowering loan underwriters with structures and guidelines that address the unique challenges of the first-time borrower. Revising mortgage guidelines and devising strategies for affordable home ownership will create valuable long-term relationships with first-time homebuyers. Just a few approaches to consider are:

  • Rethinking Loan Parameters: Mixed-use properties and home-improvement loans are typically excluded from the primary mortgage process. Banks incorporating alternative building structure options and creating allowances for home renovations in the initial mortgage parameters can substantially increase the pool of homes available to buyers. 
  • Differentiating Loan Structures: Traditional mortgages may be out of reach for many first-time buyers and may not address alternative housing solutions. While options with a higher loan-to-value ratio exist, most require mortgage insurance and are subject to increased scrutiny. Pairing conforming first mortgages with home equity loans and lines offer affordable loan structures at higher loan-to-value ratios and create long-term relationships. With proper planning, including the possible use of portfolio protection products, these structures can be offered without adding risk to the bank’s loan portfolio. 
  • Diversifying Income and Debt Guidelines: Considering tenant income and/or co-borrowers may be the only option for a potential buyer to enter the housing market. In addition, banks may also need to expand guidelines to allow for alternate sources of income, such as independent contracting income, in the underwriting decision process. 

Even with numerous obstacles, first-time home buyers offer opportunity in the mortgage origination market. Addressing the needs of this sector while avoiding the risks, lenders can create profitable mortgage and home equity portfolios, which may be the best way to mitigate the uncertainty of traditional lending in the future.

NFP is a leading insurance broker and consultant that provides employee benefits, property and casualty, retirement, and individual private client solutions through our licensed subsidiaries and affiliates. Our expertise is matched only by our personal commitment to each client’s goals.

Prepare Your Portfolio for an Economic Downturn

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portfolio-11-12-18.pngAs we reach the 10-year anniversary of the inflection point of the 2008 financial crisis, it’s the perfect time to reflect on how the economy has (and hasn’t) recovered following the greatest economic downturn since the Great Depression. If you’ve paid the slightest attention to recent news, you’ve probably heard or read about the speculation of when the nation’s next economic storm will hit. While some reports believe the next downturn is just around the corner, others deny such predictions.

Experts can posit theories about the next downturn, but no matter how strong the current economy is or how low unemployment may be, we can count on at some point the economy will again turn downward. For this reason, it’s important that we protect ourselves from risks, like those that followed the subprime mortgage crisis, financial crisis, and Great Recession of the late 2000’s.

In an interview with USA Today, Mark Zandi, chief economist for Moody’s Analytics, explained, “It’s just the time when it feels like all is going fabulously that we make mistakes, we overreact, we over-borrow.”

Zandi also noted it usually requires more than letting our collective guard down to tip the economy into recession; something else has to act as a catalyst, like oil prices in 1990-91, the dotcom bubble in 2001 or the subprime mortgage crisis in 2006-07.

As the number of predictions indicating the next economic downturn could be closer than we think continues to rise, it’s more important to prepare yourself and your portfolio for a potential economic shift.

Three Tips for Safeguarding Your Construction Portfolio In the Event of an Economic Downturn

1. Proactively Stress Test Your Loan Portfolio
Advancements in technology have radically improved methods of stress testing, allowing lenders to reveal potential vulnerabilities within their loan portfolio to prevent potential issues. Technology is the key to unlocking this data for proactive stress testing and risk mitigation, including geotracking, project monitoring and customizable alerts.

Innovative construction loan technology allows lenders to monitor the risk potential of all asset-types, including loans secured by both consumer and commercial real estate. These insights help lenders pinpoint and mitigate potential risks before they harm the financial institution.

2. Increase Assets and Reduce Potential Risk While the Market’s Hot
If a potential market downturn is in fact on the horizon, now is the best time for lenders to shore up their loan portfolios and long-term, end loan commitments before things slow. This will help ensure the financial institution moves into the next downturn with a portfolio of healthy assets.

By utilizing modern technologies to bring manual processes online, lenders have the ability to grow their construction loan portfolio without absorbing the additional risk or adding additional administrative headcount. Construction loan administration software has the ability to increase a lender’s administrative capacity by as much as 300 percent and reduce the amount of time their administrative teams spend preparing reports by upwards of 80 percent. These efficiency and risk mitigation gains enable lenders to strike while the iron’s hot and effectively grow their portfolio to help offset the effects of a potential market downturn.

3. Be Prudent and Mindful When Structuring and Pricing End Loans
As interest rates continue to trend upward, it’s crucial that lenders price and structure their long-term debts with increased interest rates in mind. One of the perks of construction lending, especially in commercial real estate, is the opportunity to also secure long-term debt when the construction loan is converted into an end loan.

Due to fluctuations in interest rates, it’s important for financial institutions to carefully consider how long to commit to fixed rates. For lenders to prevent filling their portfolio with commercial loan assets that yield below average interest rates in the future, they may find it more prudent to schedule adjustable-rate real estate loans on more frequent rate adjustment schedules or opening rate negotiations with higher fixed rate offerings (while still remaining competitive and fairly priced, of course).

Though we can actively track past and potential future trends, it’s impossible to know for sure whether we are truly standing on the precipice of the next economic downturn.

“That’s one of the things that makes crises crises—they always surprise you somehow,” said Tony James, Vice Chairman or Blackstone Group, in an interview with CNBC.

No matter the current state of the economy, choosing to be prepared by proactively mitigating risk is always the best course of action for financial institutions to take. Modern lending technology enables lenders to make smart lending decisions and institute effective policies and procedures to safeguard the institution from the next economic downturn—no matter when it hits.

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

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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.

How Pinnacle Improved the Efficiency of Construction Loan Management

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partnership-6-27-18.pngWhen banks make a construction loan on a new office building or housing development, the funds usually are not provided to the borrower in a lump sum, but instead are dispersed as various project milestones are achieved. The administration of these credits are often handled on a simple spreadsheet—one for every loan. That might work for a small community bank that only makes a handful of construction loans a year, but not for Pinnacle Financial Partners, a $23 billion asset regional bank headquartered in Nashville, Tennessee that considers construction lending to be an important business it wants to scale in the future.

Pinnacle wanted a more efficient way of administering its construction loan portfolio, particularly after a series of acquisitions of other banks that also did construction lending. “We’re always looking for ways to improve efficiency,” says Pinnacle Senior Vice President Dale Floyd. “Coming out of the recession, we were growing fairly fast, had merged a couple of banks into us and everyone was doing construction lending differently. We needed some consistency throughout the organization, and to try to be more efficient at the same time.”

And that led Pinnacle to another Nashville-based company, Built Technologies, which has developed an automated construction lending platform that not only centralizes the administrative process, but promises to be an effective risk management tool as well. “Construction loans require coordination between the bank, the borrower, the contractor, the title company and third-party inspectors to review the progress of the project,” says Built CEO Chase Gilbert. Now all of these parties are connected in real time and everyone is looking at the same information instead of information silos, and the draw process can be managed more proactively. “We bring that process online to the benefit of everyone involved.”

Pinnacle and Built were co-finalists in Bank Director’s 2018 Best of FinXTech Startup Innovation award.

The benefits to Pinnacle begin with greater speed and efficiency. “It cuts down on phone calls and emails and paper,” says Floyd. “It reduces the chances for errors … because the [loan] doesn’t have to go through so many hands.” When banks are using simple spreadsheets to administer their construction loans and a builder wants to make a draw against their loan, an inspector will have to drive to the project site and assess whether the required work has been completed, drive back and write up a report authorizing a dispersal. With the Built platform, all this happens much faster. “[All the information] is there and it’s immediate,” says Floyd.

The platform also provides the bank with an enhanced risk management capability. “We do a lot of large loans,” Floyd explains. “I can pull a report at any time of every loan I have over $1 million, by location and by builder. I can track loans that have been fully funded, or I can track loans that we’ve closed but no disbursements have been made for three months. If we see that we want to know why. What has caused this project to stall?”

And when state and federal examiners come into the bank, Floyd can “pull up any loan that they want to see and look at the inspection reports, look at the pictures and see all the numbers,” he says. “That information is there for as long as we want to store it.”

Gilbert says Built spent nine months getting to know Pinnacle and understanding the bank’s goals for construction lending before work commenced on the project. “Pinnacle is a high growth bank and it was looking for something that would allow it to scale [that business],” he says. “The bank is also fanatical about customer experience and it wanted to find a way of giving its borrowers and builders a best-in-class experience.”

Floyd says Built also made some changes to the platform at the bank’s request—for example, building in a feature allowing a borrower to overdraw their loan with the bank’s approval if the situation warrants it. “They’re constantly looking for input,” he says. “They want to make the system better all the time.” And the new platform was easy to implement, according to Floyd. “That’s one of the things I was surprised about,” he says. “The training time is very short, and it’s very user friendly.”

Enhancing the Lending Process Through Data

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Customers today expect quicker decisions, and data can empower banks to improve the customer experience. Data can also enable growth as banks gain more and better information about their customers. In this video, Steve Brennan of Validis outlines how banks can confront the challenges they face in making the most of their data.

  • How Data Has Transformed Lending
  • The Benefits of Leveraging Data
  • The Challenges Banks Face
  • Addressing Data Deficiencies

Competition for Credit Analysts Creating New Challenge for Banks

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analyst-5-3-18.pngSuccessfully recruiting a qualified credit analyst is proving to be quite a challenge in today’s banking environment. There are a number of contributing factors, including compensation compared to other industries, the evaporation of commercial credit training, and a lack of college graduates in certain areas.

With this shortage, credit analysts are highly sought after, and analysts are demanding higher wages than what the banking industry is accustomed to paying.

In the past, it has been common practice for banks to outsource loan review, compliance testing, and internal audit functions — so why not the credit analyst role?

Thin talent pools flow two ways
Historically, banks have hired recent college graduates as credit analysts with the expectation of developing them into commercial lenders and potentially future management. In theory, this practice makes sense. But in today’s market, the success rate of banks converting a credit analyst into a long-term employee seems to be the exception rather than the norm, causing many banks to abandon their commercial training programs.

Over the past decade, many banks have begun hiring seasoned credit analysts who aren’t looking to move to a customer-facing role, making it more difficult to find affordable, permanent analysts.

In recent years, outsourced providers have started meeting the demand for credit analysts. With the increase in compensation for this role, outsourcing may now be the cost-effective option. This is especially true when you factor in the time and effort spent recruiting and training, while accounting for increased efficiency or production from an experienced analyst/outsourced provider.

Banks Still Have Underwriting Control
It is clear many bankers do not want an outside vendor impacting their underwriting decisions. Banks want to make loans to familiar borrowers, and they don’t want the potential for an overly critical or negative analysis from a third party to hinder their ability to do so.

It’s important to understand that your bank will always own and control the underwriting process. The primary focus for outsourced credit analyst services is to provide all the relevant credit information in a consistent format, which will allow the bank to make a well-informed decision. Outsourcing credit analysis should not impact the bank’s underwriting practices.

Banks take pride in their ability to provide quick responses to their borrowers. Outsourcing analyst work doesn’t mean longer turnaround times. If you are considering an outsourced solution, make sure that you establish clear deadlines with your vendor.

You could also consider segmenting the credit analyst work flow between new credit requests and ongoing portfolio monitoring. It may make sense for a bank to analyze new money requests in-house, and then to outsource the less time-sensitive renewal requests and annual reviews.

Training, Retaining Analysts Can Cost You
Even if you are successful in hiring a qualified analyst candidate, the time and resources needed to properly train a new hire with little or no previous credit experience can be quite extensive. Typically, when a bank is large enough to have a pool of credit analysts, there is usually a full-time employee who helps train and develop their skill set. But if you work at a smaller community bank, you might only have one or two analysts on staff.

It is common for a senior analyst, credit officer, or a manager from the credit administration area to oversee a new analyst. But these employees usually maintain a full workload in addition, which may result in inadequate training, or an overstressed manager.

The challenge doesn’t end once you hire and train a new credit analyst. One of the biggest challenges still remains — keeping the analyst in the role. Most banks are lucky if they can keep an analyst in the role for two or three years before the individual leaves for higher pay or a more satisfying analyst role somewhere else. And then it’s time to start the recruiting and training process all over again.

At the end of the day, banks want a viable option to end the what seems like a revolving door of credit analysts. By outsourcing this role, banks have new opportunities to provide cost savings and improve quality for their customers.

The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, investment, or tax advice or opinion provided by CliftonLarsonAllen LLP (CliftonLarsonAllen) to the reader. For more information, visit CLAconnect.com.

How to Pick the Right Digital Small Business Lending Tool: Top 10 Must Have Characteristics

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lending-4-24-17.pngHaving access to online lending applications has quickly transitioned from a customer convenience to a customer expectation. It’s only a matter of time before all institutions will be providing digital access to small business lending. That much is certain. What isn’t certain is how to find the right fintech partner. Your partner should understand your institution’s lending processes and digital strategy in that space, and provide you with a solution that meets your unique objectives.

Here are the top 10 characteristics you should demand from any digital business lending partner.

1. Friend Not a Foe Business Model
It’s obvious, I know, but find a partner who is not a competitor of yours. There are business lending fintech companies that once had designs on putting banks and credit union lending departments out of business. If the businesses you serve can also go to your partner’s website and apply directly with them for a loan, they’re not a partner. They are a competitor.

2. Timely End-to-End Functionality
Current business lending processes are onerous for both the client and the bank. Applications are submitted incompletely 60 percent of the time, and data is bounced from one party to another and back again. Technology does an amazing job of doing things right the first time every time. The value in your business lending tool resides in its ability to help facilitate everything from the application to closing the loan.

3. Endorsed by a Trusted Source
Most of the financial services industry’s trusted resources and trade associations provide their members with a list of solutions for which they have completed comprehensive due diligence and identified as an endorsed solution. Entities, like the American Bankers Association, Consumer Bankers Association and others, have the resources to conduct due diligence on the companies they recommend. Leverage their expertise.

4. Control…Control…Control
The institution must be able to retain control over every aspect of the process. Your clients should never even know the tech partner exists. The brand, the credit policy, pricing, scoring, decisions, and all aspects of the customer relationship must be fully owned and controlled by the institution.

5. Customer Experience
Find a tech partner that shares your philosophy of putting the borrower at the center of the process. Look for a tool that creates an engaging, simple, and even fun environment for the application portion of the process, and results in a speedier, more efficient and convenient end-to-end process.

6. Enhances Productivity
Find tech that frees up your sales staff to sell, and allows your back office to spend minutes—not hours—making a decision on a business loan. Sales teams should spend their time growing relationships and sourcing new deals as opposed to shepherding deals through the process or chasing documentation. With the right tool, back office can analyze deals quickly and spend more time on second look processes or inspecting larger deals.

7. Builds the Loan Portfolio
Find a tech solution so good that it will draw new opportunities into your shop—even those folks who would never think about walking into a branch. And make sure the application process can accommodate both the borrower who is online and independent, as well as the borrower who wants to sit next to a banker and complete the application together.

8. The Human Touch
The most important relationship is the one between banker and customer. Don’t lose the personal touch by using technology that cuts out the value the banker brings to the relationship. Instead, find a tool that engages the relationship managers and facilitates their trusted advisor status.

9. Positive Impact on Profitability
By finding a tool that enhances productivity across the board, you should be able to reduce cost-per-loan booked by as much as two-thirds. That means even the smallest business loans should be processed profitably.

10. Cloud-Based Model
The best way to keep pace with innovation in a cost-effective manner is to find a partner that uses the latest technology, development processes and a cloud-based model, which enhances storage capabilities. Your partner should update and enhance often, and not nickel and dime you for every enhancement or upgrade.

Stick to these guidelines and you’ll be sure to find the right tool for your unique institution.

To Better Understand Bank Real Estate Credit Concentrations, Give Your Portfolio a Workout

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stress-test-4-19-17.pngBy now, the vast majority of banks with credit concentrations in excess of the 2006 Interagency Regulatory Guidance have discussed this with regulators during periodic reviews. To underscore the importance of this to the regulators, a reminder was sent by the Federal Reserve in December of 2015 about commercial real estate (CRE) concentrations. The guidance calls for further supervisory analysis if:

  1. loans for construction, land, and land development (CLD) represent 100 percent or more of the institution’s total risk-based capital, or
  2. total non-owner-occupied CRE loans (including CLD loans), as defined, represent 300 percent or more of the institution’s total risk-based capital, and further, that the institution’s non-owner occupied CRE loan portfolio has increased by 50 percent or more during the previous 36 months.

While the immediate consequence of exceeding these levels is for “further supervisory analysis,’’ what the regulators are really saying is that financial institutions “should have risk-management practices commensurate with the level and nature of their CRE concentration risk.” And it’s hard to argue with that considering that, of the banks that met or exceeded both concentration levels in 2007, 22.9 percent failed during the credit crisis and only .5 percent of the banks that were below both levels failed.

So the big question is: How to mitigate the risk? Just like the idea of having to fit into a bathing suit this summer can be motivation to exercise, the answer is to give your loan portfolio a workout.

And in this context, that workout should consist of stress testing designed to inform and complement your concentration limits. In other words, the limits you set for your bank should not exist in a vacuum or be made up from scratch, they need to be connected to your risk management approach and more specifically, your risk-based capital under stress. What’s necessary is to take your portfolio, simulate a credit crisis, and look at the impact on risk-based capital. How do your concentration limits impact the results?

For our larger customers, we find that a migration-based approach works best because the probability of default and loss given default calculations can come from their own portfolio and they can be used to project forward in a stress scenario (1 in 10 or 1 in 25-year event, for example). For our smaller banks or banks that do not have the historical data available, we use risk proxies and our own index data to help supplement the inevitable holes in data. Remember, the goal is to understand how the combination of concentrations and stress impacts your capital in a data-driven and defensible way.

Additionally, the data repository created from the collection of the regulatory flat files (the only standardized output from bank core systems) can be used for a variety of purposes. This data store can also be used to create tools for ongoing monitoring and management of concentrations that can include drill down capabilities for analysis of concentrations by industry, FFIEC Code, product/purpose/type codes, loan officer, industry and geography (including mapping), and many others. The results of loan review can even be tied in. The net result is a tool that provides significant insight into your portfolio and is a data-driven road map to your conversation with your regulators. It also demonstrates a bank’s commitment to developing and using objective analytics, which is precisely the goal of the regulators. They want banks to move past the days of reliance on “gut feel” and embrace a more regimented risk management process.

When the segmentation and data gathering is done well, you are well positioned to drive your portfolio through all sorts of different workouts. The data can be used for current allowance for loan and lease losses, stress testing, portfolio segmentation, merger scenarios and current expected credit loss (CECL) calculations, as well as providing rational, objective reasons why concentration limits should be altered.

And just like exercise, this work can be done with a personal trainer, or on your own. All you need is a well thought out plan and the discipline to work on it every day as part of an overall program designed for credit risk health.

Using Big Data to Assess Credit Quality for CECL

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CECL-4-7-17.pngThe new Financial Accounting Standards Board (FASB) rules for estimating expected credit losses presents banks with a wide variety of challenges as they work toward compliance.

New Calculation Methods Require New Data
The new FASB standard replaces the incurred loss model for estimating credit losses with the new current expected credit loss (CECL) model. Although the new model will apply to many types of financial assets that are measured at amortized cost, the largest impact for many lenders will be on the allowance for loan and lease losses (ALLL).

Under the CECL model, reporting organizations will make adjustments to their historical loss picture to highlight differences between the risk characteristics of their current portfolio and the risk characteristics of the assets on which their historical losses are based. The information considered includes prior portfolio composition, past events that affected the historic loss, management’s assessment of current conditions and current portfolio composition, and forecast information that the FASB describes as reasonable and supportable.

To develop and support the expected credit losses and any adjustments to historical loss data, banks will need to access a wider array of data that is more forward-looking than the simpler incurred loss model.

Internal Data Inventory: The Clock is Running
Although most of the data needed to perform these various pooling, disclosure and expected credit loss calculations can be found somewhere, in some form, within most bank’s systems, these disparate systems generally are not well integrated. In addition, many data points such as customer financial ratios and other credit loss characteristics are regularly updated and replaced, which can make it impossible to track the historical data needed for determining trends and calculating adjustments. Other customer-specific credit loss characteristics that may be used in loan origination today might not be updated to enable use in expected credit loss models in the future.

Regardless of the specific deadlines that apply to each type of entity, all organizations should start capturing and retaining certain types of financial asset and credit data. These data fields must be captured and maintained permanently over the life of each asset in order to enable appropriate pooling and disclosure and to establish the historical performance trends and loss patterns that will be needed to perform the new expected loss calculations. Internal data elements should focus on risks identified in the portfolio and modeling techniques the organization finds best suited for measuring the risks.

External Economic Data
In addition to locating, capturing, and retaining internal loan portfolio data, banks also must make adjustments to reflect how current conditions and reasonable and supportable forecasts differ from the conditions that existed when the historical loss information was evaluated.

A variety of external macroeconomic conditions can affect expected portfolio performance. Although a few of the largest national banking organizations engage in sophisticated economic forecasting, the vast majority of banks will need to access reliable information from external sources that meet the definition of “reasonable and supportable.”

A good place to start is by reviewing the baseline domestic macroeconomic variables provided by the Office of the Comptroller of the Currency (OCC) for Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank stress testing (DFAST) purposes. Because regulators use these variables to develop economic scenarios, these variables would seem to provide a reasonable starting point for obtaining potentially relevant historic economic variables and considerations from the regulatory perspective of baseline future economic conditions.

Broad national metrics—such as disposable income growth, unemployment, and housing prices—need to be augmented by comparable local and regional indexes. Data from sources such as the Federal Deposit Insurance Corporation’s quarterly Consolidated Report of Condition and Income (otherwise known as the call report) and Federal Reserve Economic Data (FRED), maintained by the Federal Reserve Bank of St. Louis, also can be useful.

Data List for CECL Compliance

critical-internal-data-elements-small.png

Looking Beyond Compliance
The new FASB reporting standard for credit losses will require banks to present expected losses in a timelier manner, which in turn will provide investors with better information about expected losses. While this new standard presents organizations of all sizes with some significant initial compliance challenges, it also can be viewed as an opportunity to improve performance and upgrade management capabilities.

By understanding the current availability and limitations of portfolio data and by improving the reliability and accuracy of various data elements, banks can be prepared to manage their portfolios in a way that improves income and maximizes capital efficiency.