Perspectives: Strategic Issues

December 26, 2017
Community Mindset: Bearing the Burden

One of the most welcome developments for financial institutions over the past several years has been the optimistic conversation – and occasional action – surrounding the topic of regulatory relief. Particularly for community institutions, many of which felt unfairly scapegoated and unduly put-upon in the wake of the financial crisis, efforts by several agencies to ease the burden and costly drain on scarce resources associated with often disproportionate regulation have been long in coming.

The truth, however, is that there is quite a burden to unload, and it’s going to take time for institutions to truly see and feel the effects of this easing. Perhaps that’s why so many of the executives surveyed for Community Mindset: Bank and Credit Union Leadership Viewpoints 2017 still view the regulatory burden to be among the greatest challenges facing their institutions (Figure 1). At 62%, it registered as the top concern from a slate of eleven possibilities, outpacing the challenges posed by competition from other institutions and attracting new/younger customers.

Although responses across all asset ranges reflected the challenge of the regulatory burden to roughly the same degree, those institutions in the smallest asset category ($200-$499 million) stood out as the most challenged – likely due to the proportion of resources encompassed by regulatory-related tasks in a smaller institution – with 40% of these respondents identifying it as their top challenge versus 31% on average of other asset sizes. Likewise, banks seem to be feeling the pressure more acutely than credit unions, with almost 66% of bank executives viewing the regulatory issue as either extremely or somewhat challenging, compared to just 51% of their credit union counterparts.

Further, nearly two-thirds of survey participants ranked regulatory compliance first or second among a slate of five risk management priorities (Figure 2).

While 53% of respondents are getting by with what they feel to be a “reasonable or manageable” regulatory burden, 34% characterized their regulatory load as “a little too heavy” and 14% labeled it “overwhelming.” Trying to pinpoint the most common regulatory headache plaguing institutions, however, yielded an extremely wide range of responses – compliance costs (14%) and changing laws/regulations (14%) were the only two concerns to muster double-digit percentage consensus.

Regulation is, and will continue to be, a reality and cost of doing business for financial institutions. And while regulators’ incremental efforts to help reduce the burden are likely well appreciated throughout the industry, it’s clear from the opinions of community bank and credit union leaders that there’s still a long way to go to get to a level that both sides can accept as reasonable.

Research taken from the FMS-commissioned study Community Mindset: Bank and Credit Union Leadership Viewpoints 2017, a survey of 400 senior executives representing community-based banks and credit unions.

December 18, 2017
Community Mindset: Millennial Musings

As they have grown into the largest segment of today’s workforce, Millennials have garnered more than their share of the industry press, with endless studies and pieces focusing on everything from their attachment to cell phones to their comparative lack of savings compared to other generations.

What has been easy to overlook amid this onslaught, however, is the plain fact that the future is now as far as Millennials are concerned. According to generational researchers, Millennials in 2017 range in age from 22 to 40, and by this measure, they made up at least a third of the respondents surveyed for Community Mindset: Bank and Credit Union Leadership Viewpoints 2017.

In other words, Millennials are no longer just hard-to-please and hard-to-keep young employees and customers. They are now the leaders at community institutions across the U.S., interested in bringing their generational brethren into the fold. But even with these eyes on the inside of many institutions, this has proven to be an ongoing challenge.

Attracting the Young
Asked how difficult it was to attract new and younger customers, 22% of respondents deemed it extremely challenging, while another 32% found it somewhat challenging. Survey participants ranked attracting new and younger customers third among a list of eleven challenges facing their institutions – behind only their regulatory burden and competition from other banks and credit unions.

Nevertheless, while respondents may find it vexing to woo Millennials, many seem confident that they’re stepping up to meet the challenge, with 61% of all respondents either very or somewhat satisfied with their institution’s appeal to Millennial customers. While 61% is a healthy number, when respondents were asked to rate their satisfaction with six items, appealing to Millennial customers still had the lowest rate of satisfaction – lagging behind areas such as digital banking (74%) and payment technology (76%).

The Importance of Improving
Even as community institutions might not be uniformly enthusiastic about their appeal for young customers, they do recognize the importance of getting better.

Of those respondents who expressed less than a “very satisfied” opinion of their appeal to Millennial customers, 69% saw this as an important area in which to improve. To put this in perspective, branch delivery, which was ranked only slightly higher than appeal to Millennials in satisfaction (65% compared to 61%, and fifth out of the six items), was not similarly prioritized for improvement by respondents (56% compared to 69%, and last out of the six).

In other words, the importance of improving was not based on how badly the institution felt it was performing; rather, these leaders seem to realize that catering to the younger generations is a key factor for their institutions’ future success.

The Struggle is Real
As the financial industry continues to struggle to figure out what Millennials want from their bank or credit union, the conundrum is proving more difficult for some institutions than others.

For example, the challenge of attracting new and younger customers was greatest for those institutions on the low end of the asset scale, with 61% of these respondents (in the $200-$499 million asset range) finding the problem tough to tackle, compared to a 52% average among the other asset sizes. Further, community banks (57%) see the Millennial issue as a much bigger challenge than do credit unions (45%).

Likewise, when it comes to measuring their institution’s appeal to Millennials, the smallest institutions ($200-$499 million) again see the biggest issue, with 21% in this range expressing dissatisfaction with their appeal to Millennials, compared to an average of 12% among the other asset sizes. The largest institutions ($2-$4.9 billion), on the other hand, were most likely to be pleased with their efforts, with 65% expressing satisfaction, compared to 59% on average from the asset sizes below them.

Those community banks and small institutions that see themselves as behind the curve with Millennials, however, are also among the most eager to try and catch up – 34% of community bank executives who weren’t “very satisfied” with their institutions’ appeal to Millennials said it was very important to improve, versus just 24% of those in credit unions with the same outlook. Similarly, 41% of executives from institutions with $200-$499 million in assets said it was very important to improve, while only 29% from the larger asset sizes on average prioritized improvement.

Whether reevaluating branches or expanding their digital presence, community institutions know that bringing Millennials into the fold is crucial to their future growth. The question going forward will be how best to get the attention of these customers of tomorrow, and how best to show them the value of a long-term relationship with their community institution.

Research taken from the FMS-commissioned study Community Mindset: Bank and Credit Union Leadership Viewpoints 2017, a survey of 400 senior executives representing community-based banks and credit unions.

December 7, 2017
Community Mindset: Reassessing the Branch Network

Branches have been a touchy subject for community institutions for some time, with the industry split between the idea that the physical branch has outlived its utility as a viable channel and the notion that it is but a glittering high-tech makeover away from reclaiming its former prominence for today’s customers.

There may be no clear consensus in this debate, but one thing is certain – thousands of branches have closed since the financial crisis of 2008, and the march in that continued direction is fairly clear. While they cannot dispute the numbers, proponents of the physical branch remain optimistic about its future prospects, attributing many of those closings to the consolidation of larger institutions in the wake of mergers and downsizing.

Yet whether or not the physical branch is actually dying, it is indisputable that the strategic value of their branch networks has changed dramatically for community institutions over the past decade.

Low Priority
When asked to rate the importance of a variety of potential factors for growth in their institutions, respondents in the FMS study Community Mindset: Bank and Credit Union Leadership Viewpoints 2017 placed a low priority on adding branches, with 47% viewing it as either very or somewhat important – good for last place among eleven choices; an additional 31% of respondents were neutral on whether or not adding branches would help them grow. While such attitudes do not necessarily portend doom for the future of the physical branch, neither do they demonstrate the robust confidence in a longstanding delivery channel that may have existed just a few short years ago. Further, respondents did not prioritize branches when it came to potential cost-saving measures within their institutions, with only 18% identifying branch expenses as the best opportunity for cost management. On the bright side, this could indicate that institutions have no plans to scale back their branch networks in search of savings. However, it may also signal that institutions are running their branches as close to the bone as possible already, thus leaving them with little left to trim.

Despite the seeming lack of enthusiasm for branches, 65% of respondents said they were satisfied when asked for their opinion on branch delivery at their institution, with those in the smallest asset grouping ($200-499 million) most likely to be very satisfied. However, when ranking a variety of their concerns, satisfaction with branch delivery came in only fifth out of six possibilities, lagging behind options such as satisfaction with payment technology (76%), digital banking (74%), cybersecurity (73%) and data analytics (68%).

Respondents who were not “very satisfied” with the six presented concerns were further asked how important it was for them to improve in these areas. Of the respondents who weren’t very satisfied with branch delivery at their institution, 56% deemed it important to improve while 35% were neutral on whether it was important. In this case, branch delivery ranked dead last in the six areas considered important to improve, falling in line behind cybersecurity (79%), payment technology (71%), appeal to Millennial customers (69%), digital banking (67%) and data analytics (64%).

Holding Steady
Why has the branch network fallen on the to-do lists of community institution leaders? Perhaps the best answer might be the easiest: if it’s not broken, there’s no need to fix it. For example, 46% of respondents said that they’re satisfied with their current branch network, and don’t feel the need to either add or close branches – an opinion held most strongly among those institutions in the smallest ($200-499 million) and largest ($2-4.9 billion) asset groups.

Supporting the “if it’s not broke” hypothesis, only 18% of respondents said they were looking to close branches, while 36% said they were actually hoping to expand and add branches. After all, why change anything when 72% of respondents said their customers were satisfied with the branch experience? These institutions might just be keeping things how their customers like them (for now).

Additional insight on the future of branches comes from looking at what’s rising to the top of priorities as branches drift toward the bottom – namely, technology. Among the eleven growth priorities offered for ranking, technology came out on top (73%) while branches languished in last. Similarly, when respondents were asked about the best opportunities for cost management, 65% saw improving efficiency through technology as their best bet, compared to the 18% that went with branch expenses. Finally, when asked about their satisfaction with and investment in a variety of areas, improving branch delivery fell behind a host of technology-related concerns, including cybersecurity, payment technology, digital banking and data analytics.

The Evolution of the Branch
Of course, technology investment and a healthy branch network aren’t necessarily mutually exclusive pursuits. In fact, incorporating technology into branches was important to many respondents in the survey. When asked about branch upgrades, 36% said they planned to add features, with 33% expressing specific interest in interactive tellers. An additional 24% were redesigning, while 27% had no plans to change or update their branches at this point.

Perhaps that 27% were waiting, like the rest of the industry, to see just where branches might be headed. The drumbeat of technology is, of course, inexorable, but it’s hard to say for certain what the ultimate affect will be on the look, feel and ultimate viability of the community institution branch.

Research taken from the FMS-commissioned study Community Mindset: Bank and Credit Union Leadership Viewpoints 2017, a survey of 400 senior executives representing community-based banks and credit unions.

AUGUST 16, 2017
Building an Optimal Investment Portfolio
By Robert B. Segal, CFA, Atlantic Capital Strategies, Inc.

Bank investment portfolios are an increasingly important part of balance sheet management. As portfolios have grown by 5.9% over the past year, according to the FDIC, they also produce a larger share of earnings. However, regulatory challenges and the low interest rate environment have pushed some into lopsided positions, such as high concentrations of agency notes and collateralized mortgage obligations (CMOs), with those institutions dealing with what are now sub-optimal portfolio allocations.

These investment portfolios show heightened risk exposures, whether through maturity extension, early call features or declining levels of income – less palatable sources of risk in an industry currently focused on improving earnings. In order to boost long-term performance while mitigating risk, investment officers should keep an eye on the following key areas.

Target Duration
Investment policy statements describe the framework by which the institution manages its portfolio. One goal is to enhance profitability within the overall asset/liability management objectives, while a second aim is to establish a process for implementing specific measures to manage sensitivity to interest rate changes.

Accordingly, management should establish a target level of duration that reflects the institution’s asset/liability position, income requirements and risk tolerance. Academic studies consistently show that longer-duration portfolios provide higher levels of income. At the same time, highly-leveraged institutions need liquidity to fund loans, and this may reduce the desired level of price sensitivity, causing the investment officer to “shorten-up.”

Maintaining duration, moreover, is an essential factor in preserving margin and maximizing net interest income. As portfolios age, duration can decline unless cash flows are reinvested back out on the curve; this “opportunity cost” limits earnings potential. Similarly, portfolios comprised exclusively of mortgage securities can extend if prepayments lag initial projections, creating unexpected interest rate risk. Investment officers should closely monitor their portfolios and take steps to ensure target durations are preserved to protect net interest income.

Many portfolios become heavily weighted toward certain “comfortable” sectors. The returns fixed-income investors receive are determined by various factors, such as volatility of rates, credit and yield curve slope. An emphasis on callable agencies, for example, implies a reliance on returns from taking extension risk or prepayment risk.

With an expected drop in market rates, this institution will receive unwanted funds which must be reinvested at lower yields. Conversely, calls slow down in a rising-rate environment, providing less cash to put to work at better yields or to fund loans. A diversified portfolio (more call-protected assets, in this case) would keep cash flow fluctuations to a minimum, leading to improved portfolio performance.

Cash Flow
It is recommended that the treasury group prepare cash flow projections in a base case, as well as several alternate scenarios. An institution exposed to mortgage security prepayments, for example, can act in advance to protect against a decline in income in a falling-rate environment by either pre-investing or realigning the portfolio. The cash flow projections provide the information necessary to understand the position and evaluate suitable strategies, with the ultimate goal of establishing an optimal cash flow profile.

Bond Ladder
A laddered portfolio consists of securities that mature in successive years, starting in the short term and extending out to five years or longer. Assembling a stable basket of cash flows avoids locking in all one’s funds at “low” yields, while enabling the investor to pick up some additional income.

The benefit of a ladder is that as rates move higher, bonds coming due in the near term can provide funds for reinvestment when the alternatives may be more attractive. Depending on the institution’s preference and individual situation, the principal can be put to work at the desired maturity. If current yields are higher than the bonds rolling off, the institution is able to increase overall returns, boosting portfolio performance.

Fixed vs. Floating
Many investment officers wonder about the optimal strategy for deploying assets – whether to put on longer-term fixed-rate investments that pay a higher coupon or add floating-rate instruments that would benefit if rates rise. The investment officer might be considering two options: a five-year fixed-rate note yielding 2.4% or a similar term floating-rate bond priced at 90-Day LIBOR (1.3%) plus 50 basis points, for a current yield of 1.8%.

If the market forecast is correct, then the yield for the floating-rate bond will increase 25 basis points in September 2018 and a similar amount the following year – bringing the yield to 2.3% at September 2019. By contrast, the institution will have received a constant 2.4% for the fixed-rate option. Assuming a $1 million investment, the fixed-rate bond provides interest income of $72,000 over the three-year time horizon, compared with $65,250 for the “floater.” Even as the yield curve has flattened, fixed-rate assets may still provide higher levels of current income than floating-rate alternatives in the intermediate term.

Best Execution
In light of recent advances in technology, regulatory agencies such as FINRA have reiterated their commitment to ensuring best execution as a key investor protection requirement. FINRA stated in a November 2015 regulatory notice, for example, that the market for fixed-income securities has evolved significantly and transaction prices for most securities are widely available to market participants.

Broker/dealer transaction costs can vary greatly based on the scope of the transaction and access to the most liquid dealers. For example, the Bid-Ask Spread Index from MarketAxess shows that block trades on actively traded corporate bonds currently have a 3-basis-point bid-ask spread, and “odd lots” trade at 7 basis points. Individual transactions often trade at higher spreads, indicating that investors may be “leaving money on the table.” A more diligent approach toward trading efficiencies could help support the bottom line.

Municipal Bonds
Banks have boosted their holdings of municipal bonds steadily over the past decade, according to Federal Reserve statistics. Industry reports generally show that institutions holding larger percentages of municipal bonds tend to be the high performers, and banks holding at least 30% of their investment portfolios in munis are typically found in the first quartile for investment yield.

A primary benefit of municipal bonds is the long period of call protection. Bank treasurers may be relatively certain they’ll hold on to the initial yield for seven to ten years, regardless of interest rate movements. With considerable optionality on most bank balance sheets, municipals provide much-needed predictable cash flow. In addition, the municipal curve remains steep, providing some price protection for a rising-rate environment.

The Bottom Line
Taking some of these steps may enable management to build more efficient investment portfolios that generate higher levels of income over time. Building predictable cash flow characteristics provides the flexibility to manage the portfolio effectively within the context of the balance sheet, while also leading to stable returns.

Of course, the institution should consider its asset-liability position when making these decisions. Investment officers should also continue to maintain robust risk management practices, keeping interest rate risk exposure at reasonable levels.

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

Robert B. Segal, CFA, Atlantic Capital Strategies, Inc.
Robert B. Segal is the founder and CEO of Atlantic Capital Strategies, Inc., and has over 35 years of experience in the banking industry, having worked in several community banks with roles in mortgage banking, sales and trading and asset-liability management. Bob is also currently a Director-at-Large on the FMS Board of Directors.

May 17, 2017
Top Five Attributes of High-Performing Institutions   
By  Danny Baker, Vice President – Market Strategy, Financial and Risk Management Solutions, Fiserv

Executives, employees, customers and shareholders want it all when it comes to the management of a financial institution – high growth, profitability and efficiency. Financial managers know that there is a delicate balance required to achieve strategic growth while managing expenses, but high-performing financial institutions are successfully able to walk that line every day.  

Every organization can learn from top performers, including understanding where and why they win and what drives their profitability. What do they do better than others to balance growth with efficiency? Working with a group of industry-ranked, high-performing Fiserv clients on a daily basis and observing their challenges, opportunities and best practices, we have found that these institutions shared five differentiating attributes.

1. Forward-Looking Management
So many economic variables can affect a financial institution's future, and high performers successfully assess those factors, run multiple future scenarios and manage to those possibilities. If things change, they can more quickly understand the effects and make appropriate adjustments. Assumptions about the future underpin predicted strategies, including long-range plans and budgets. Instead of simply taking a historical view – or looking at what's happening right now – high-performing financial institutions constantly review forecasts and future scenarios to better assess their environment, customers, market and competition.

2. Strategic Planning Discipline
A good strategic process relies on data analytics and scenario creation – a forward-looking management discipline that runs multiple scenarios and analyzes the underlying drivers of success. High-performing financial institutions don't just look at superficial numbers and metrics. Rather, they consider the drivers of success and underlying assumptions and then actively measure against those assumptions. Unfortunately, many organizations employ the wrong metrics to determine if a strategy is working. Using data analytics can help financial institutions understand the market and how to measure success.

3. Effective Information Management 
Data analytics provides a wealth of insights, but organizations must determine what they really need to know. High-performing financial institutions effectively manage data and link business decisions to that information. They focus on forward-looking, prescriptive data versus information about what has happened already, constantly asking, "How can we do this better?" Just as importantly, they ensure key information is widely distributed within the organization.

4. Effective Control Structure
Are we achieving what we set out to achieve? Are we measuring and driving the right results? Establishing appropriate control structures helps ensure the desired results are achieved without destroying another aspect of performance. For example, a financial institution could meet its profitability goal, but do it in a way that doesn't best meet the needs of its customers, and in the process, damage trust, reputation and relationships.

5. Adaptable Risk Management Frameworks
Financial institutions are in the business of balancing risk – especially credit risk – and reward. The risk environment can change quickly due to macroeconomic factors, such as changing interest rates, unemployment and home values, as well as the organization's policies and appetite for risk. Effective risk management at a financial institution is closely tied to profitability. To support high-growth initiatives, risk management frameworks and accompanying strategies must be particularly adaptable to change.

Lessons from High Performers

Behind each of the five attributes that helps define and differentiate high performers are two factors: data analytics and the discipline to execute on key strategies.

If someone asked you to name your institution’s best customers, could you? Maybe you'd list those with the most money, but those may not be the accounts that are the greatest contributors to your profitability. It's very difficult to establish a good strategy – and execute on that strategy – if the institution doesn't understand what drives its profitability. High performers get it. They see the link between information, strategic thinking and the actions needed to achieve their goals.

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

Danny Baker, Vice President – Market Strategy, Financial and Risk Management Solutions, Fiserv
Danny Baker is the Vice President of Market Strategy within the Financial and Risk Management Solutions division at Fiserv, Inc. He is responsible for the overall market strategy and business development for the company’s risk management, performance management and enterprise financial accounting solutions.

May 10, 2017
How Risk Ratings Can Enable Optimal Growth for Financial Institutions 
By Elise Hauser, Product Marketing Manager, Sageworks

Today’s banking industry is defined by tight interest margins and increased regulatory oversight. At the same time that banks and credit unions are facing these challenges, threats from alternative lenders and mega banks make it imperative that institutions grow in order to achieve economies of scale and remain competitive and profitable. These opposing pressures mean that community banks and credit unions must optimize their opportunities to grow profitably while mitigating risk.

One way to increase profitability is to reduce the costs associated with managing risk. Banks and credit unions with efficient risk management processes will spend less time analyzing and evaluating risk in their portfolios, and thus will lower the cost of doing business. For many institutions, a best practice is a comprehensive risk-rating system, that -- when properly applied -- streamlines risk management across the institution.

Assigning a Number
A risk-rating system is deceptively straightforward: a reduction of the unique combination of risk factors on each individual loan down to one number, for example, a 3. Once a loan has been risk-rated as a 3, the institution is able to use that information to make decisions about that loan and the portfolio. This risk rating can also be used at nearly every stage of the credit process to lower the cost of managing risk. Developing, implementing and maintaining a risk-rating methodology that accurately and consistently measures risk can be challenging, but it offers tremendous payout.

Risk ratings are also useful in that they allow the bank or credit union to talk about risk in a standardized language across departments and across the life of the loan. Under a given risk-rating methodology, “a 3 is a 3,” meaning that everyone from the lending department to loan administration to those determining the ALLL have the same understanding of the risk level of a loan that is risk-rated as a 3. Distilling the credit risk of a loan into a single metric also allows the institution to track it over time and to see both the evolution of a single credit, as well as the portfolio as a whole.

One important note about risk ratings is that they are not in and of themselves a risk-reducing tool. They simply function to identify and categorize risk so that the institution can make informed decisions on pricing, terms and reserves based on its individual risk appetite. A strong risk-rating system allows the institution to optimize the balance of risk and reward that is right for them.

Ultimately, the single most important reason to make sure your risk-rating methodology is up to snuff is because risk ratings come into play at every stage of the life of the loan. If your risk-rating methodology is comprehensive and standardized, you have a powerful tool. If it is inconsistently applied or has gaps in coverage, then at best you aren’t able to use risk ratings when evaluating risk; at worst, you are making decisions based on faulty data.

How Ratings Help
To get a sense of just how crucial risk ratings are to every part of the credit process, consider a few different ways risk ratings are used at various points in the life of the loan:

Credit Analysis
Risk ratings come in handy even before a loan is booked. By assigning a risk rating to a loan during the initial spreads for a proposed loan, the analyst is able to see a holistic picture of the risk of that loan, and make a lending recommendation based on that information.

Loan Pricing
An important consideration when pricing loans is the level of risk the institution is taking on with that credit. Especially with pressures to price competitively, it is important that when the institution makes a pricing decision, it is adequately compensated for that risk. By risk-rating proposed loans, the loan officer or lending committee can make an informed decision about what price to set, or whether to walk away from the deal entirely.

Loan Administration
Throughout the life of any loan, it is important that the loan is risk-rated at regular intervals, such as annual reviews. The loan administration department plays a critical role in making sure that updated risk ratings are reflected in the management of the loan. For example, if a loan were to receive a worse risk rating at annual review, the institution may want to begin collecting additional documentation, update the terms of the covenants or make other changes to the way the loan is managed. These changes are implemented through the loan administration department, so they are also able to leverage the risk-rating on a loan to reduce risk through loan management.

ALLL and Stress Testing
When it comes to managing the risk of the entire portfolio, risk ratings come in handy in a variety of ways. Beyond just grouping loans by risk rating to stress test a particular segment, some ways risk ratings can be helpful in portfolio risk management include:
Migration of risk ratings by segment
Exposure in watch, special mention or substandard ratings
Changes in risk ratings under stress scenarios
Risk rating by loan officer

In today’s banking environment of tight margins and ever-increasing regulatory oversight, it is crucial that community banks and credit unions find ways to grow without compromising the desired risk levels of their portfolios. Risk ratings are crucial to accomplishing risk-managed growth. By implementing a robust risk-rating methodology, banks and credit unions can make credit risk management easier and more effective at every stage of the life of the loan.

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

Elise Hauser, Product Marketing Manager, Sageworks
Elise Hauser is a product marketing manager at Sageworks, where she manages new product marketing for Sageworks banking solutions.

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.

Track movement of loans by segment
to identify trends in portfolio growth
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.