FEBRUARY 15, 2017
Analyzing Your Institution’s Portfolio Risk Within Your ALLL
By Jamie Buzzerio, Sageworks
The allowance for loan and lease losses (ALLL) for financial institutions is typically viewed as a compliance requirement, with a prominence in external audits and examinations that demands that calculations and data be scrutinized to ensure accuracy and transparency. However, astute institutions should also consider evaluating how the information contained within this allowance function can be leveraged for other strategic insights.
For example, the following four scenarios are ways that management can use existing allowance-calculation data to better understand the risk in their portfolio and provide even more risk intelligence.
Institutions can review growth patterns of the loan portfolio by looking at their segments and by reviewing their balances. If a specific segment has grown significantly, the institution can begin to identify and document the reasons for changes in loan demand and supply.
On its own, this data may not tell the institution precisely where to focus its growth efforts, but it can certainly be a starting point in understanding where lenders are seeing the most success, or perhaps where the most time and resources are being allocated. If the results do not align with management expectations, the lending strategy may need adjustment.
This type of analysis can also be extending to cover trends in delinquencies, restructuring of problem assets and concentrations. In combination with growth patterns, these trends show where the institution’s growth has been healthiest.
By collecting and archiving loan data each period, all of this information is available for detailed review and trend analysis. The more granular the data (i.e., monthly instead of quarterly) the faster the institution can begin to identify critical trends, and it goes without saying that the integrity and accuracy of the data are paramount.
Measure overall asset quality
Asset quality indicators that are used in loan-level ALLL calculations can also be used as a benchmark for portfolio credit quality over time and for comparison to peer institutions. A few commonly used ratios that capture portfolio performance as it relates to the allowance include:
■ Allowance to Total Loans
■ Allowance to Net Losses
■ Allowance to Nonaccruals
■ Recoveries to Total Loans
■ Net Losses-Earnings Coverage Ratio
■ Nonaccrual Loans to Total Losses
Details from the ALLL and benchmarks like these are an important part of the management reporting process, and can provide clues to both the board and examiners regarding the health of the institution.
During the business cycle, the collectability of certain loans may change in light of changing economic conditions. If an institution grants loan concessions without accurate exception reporting as part of ALLL, what will happen if those loans take a turn for the worse? The loss needs to be recognized immediately, as opposed to reserving specific dollar amounts over an allocated period of time. This is where the FASB’s current expected credit loss (CECL) model becomes relevant, by requiring institutions to set reserves for the full life of their loans.
Evaluate loss experience to identify trends
Begin by reviewing charge-offs based on different characteristics, such as location, NAICS, MSA, loan size, type of loan or loan officer. Because charge-offs and recoveries are tracked quarterly, if not monthly, this information is available for use in different reports. Information from the pooled loan summary can allow an institution to use these specific charge-off characteristics to examine the loan portfolio in more detail as such:
■ The location and size of charged-off loans can help determine which geographic areas may be presenting the most issues, as well as the extent of those relationships
■ Segment data can reveal if a certain concentration is causing more issues than others
■ Loan officer information can highlight if individuals are making riskier loans and how rates are priced based on risk
Loans should also be reviewed by segmentation to determine which loans show the best source of repayment. This includes the review of workout experiences and loan liquidations, which can help in evaluating expected recoveries, as well as enhancing future lending policy and potential covenants for new loans.
Create a stress test to bolster the institution’s risk management framework and supplement ALLL
An institution estimating loss rates by pool within the allowance can use these loss rates as the framework for portfolio-level or top-down stress tests, with existing loss rates as the baseline scenario. With data from the ALLL, the institution can:
■ Stress test the ALLL to ensure adequacy of the allowance
■ Identify key factors used for stress testing
■ Modify qualitative adjustments
■ Provide supporting documentation
■ Expand concentration stress testing
Risk can be identified by understanding trends and shifts in loan concentrations, delinquencies and other areas. Understanding the risk in a portfolio will help the institution modify its lending strategy, whether by a shift in concentration or an overall policy change.
Loss experience and historical data that is collected as part of the ALLL can provide direction for an institution’s credit risk analysis and subsequent action plans for risk management. In addition to these specific exercises, a data-driven ALLL also improves data-collection practices at the institution, a strength that will be all the more important under the coming CECL model.
Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.
About the Author
Jamie Buzzerio, Senior Risk Management Consultant, Sageworks
Jamie Buzzerio is a senior risk management consultant at Sageworks and is responsible for working with financial institutions with their ALLL and stress testing processes. Jamie has twenty years of experience in the financial industry, and has served in a VP role for several positions as an impairment manager, credit administration manager and portfolio manager.