Loan Portfolio Management
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1 Loan Portfolio Management Michael Wear
2 ALLL Activity - Summary ($000) /2016 Beginning 2,456 3,471 4,343 6,513 Balance Provisions 2,000 2,000 8,000 6,000 Net Charge-offs Ending Balance (985) (1,128) (5,873) (5,891) 3,471 4,343 6,470 6,622 ANB 0.92% 1.07% 1.60% 1.66% 3 An institution s failure to analyze the collectability of the loan portfolio and maintain and support an appropriate ALLL in accordance with GAAP and supervisory guidance is generally an unsafe and unsound practice. -FIL
3 The ALLL represents one of the most significant estimates in an institution s financial statements and regulatory reports. -FIL Estimate of current* credit losses Known (loans individually analyzed) Unknown (inherent, remainder of loan portfolio) (Contra Account) to Total Loans & Leases Provisions are Expensed Methodology Consistent with Regulations and GAAP/IFRS Commensurate with the bank s size & loan portfolio composition Self-contained and well-documented * until Current Expected Credit Loss model is required 6
4 When available information confirms that specific loans, or portions thereof, are uncollectible, these amounts should be promptly charged off against the ALLL. -FIL
5 CAMELS Regulatory Actions Capital Requirements (Basel III) Financials (FASB) Call Reports SEC Governance 9 Pre-Credit Crisis (< 2005) Public Banks: SEC Considerations Had large, unallocated reserves Reserving for future, speculative events Lack of transparency in public filings Private Banks: Pre-set reserve % for Pass, SM, Sub, & Doubtful risk ratings Banks Response: reduce ALLL & Provisions to bolster earnings Credit Crisis Massive Charge-offs, Replenishing ALLL, Capital Planning Change in Methodology to Current Expected Credit Loss modeling (CECL) 10
6 ALLL should peak PRIOR to surge in delinquencies The opposite has been true Creates contra-cyclical or reactionary results 11 FDIC All Institutions 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Mar
7 FDIC All Institutions 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Mar
8 Anonymous National Bank -- Peer Comparison /2016 ANB 0.92% 1.07% 1.60% 1.66% Peers 1.40% 1.46% 1.54% 1.51% 15 Anonymous National Bank -- Peer Comparison /2016 ANB 2.09x 0.49x 0.56x 0.86x Peers 1.86x 2.05x 1.66x 2.15x 16
9 Anonymous National Bank -- Peer Comparison /2015 ANB 3.52x 3.85x 1.10x 0.28x Peers 4.84x 4.32x 3.40x 4.19x 17 A stagnant, preset level We reserve at 1.50% of Total Loans. An unsubstantiated total of buckets of reserve Pass-rated = 1% Special Mention = 5% Substandard = 15% Doubtful = 50% A goal to just shoot for with future earnings & provisions We want to get to 2.00% of Total Loans by FYE. 18
10 Move Unexpected Losses to Expected Qualitative Factors Protect against volatile earnings swings Provisions Long-term, consistent profitability ALLL Adequacy Protect Capital against large charge-offs Provisions Properly value loan portfolio by quantifying inherent risk ALLL Adequacy with CECL modeling Consistent behavior aligned with credit policy Monitoring, Risk Ratings, Workouts, Chargeoffs 19 At least Quarterly ALLL Amount Calculation Provision Amount Determination 20
11 At least Annually ALLL policies and procedures: Data Capture and Information supplied Loan Review System and Controls Staff Qualifications & Independence Effective Loan Grading Problem Asset Identification and Workout Prompt Charge-offs ALLL Model Assumptions and Conclusions 21 Periodically Validate ALLL Methodology By an Independent Third-Party Internal Compliance, Audit External Accountant or Contractor Testing to include: Data used Methods used (FASB, Regulatory Guidance) Conclusions Check those Qualitative / Environmental Factors 22
12 Loan Segments (Pools) (FAS 5; ASC 450) Impaired Loans (FAS 114; ASC ) Qualitative Factors ALLL 23 Loan Segments (Pools) Groups of Loans with Similar Risk Characteristics or Call Report Categories Historical Loss Rates Lagging Indicator Extraordinary Loss Rates De Novo Banks Sample Loan Pools: CRE-Owner Occupied CRE-Investor Construction & Development Commercial Consumer Residential-1 st Residential Jr. Credit Card, O/D s 24
13 Impaired Loans Individually Evaluated Loan-by-Loan Basis If Impaired 3 Methods Liquidation Value of Collateral PV (Present Value) of Cash Flow Observable Market Value Not Well Documented Not Critical Enough Holding Period Costs 25 Qualitative Factors Adjustment (+) to Historical Loss Rates Leading Indicators Concentrations Local Economic Data Collateral Valuation Q-Factor Examples: Economic Conditions Anticipated Change in Loan Volume Trends in Past-dues & Non-Accruals Industry trend for large (Ag, CRE) loan concentrations New Lenders or Staff 26
14 Peer Groups to compare and understand trends Cannot use Peer Group Comparison to determine adequacy of ALLL Typical Ratios used to determine adequacy: ALLL-to Total loans Adversely classified or graded loans Past-due and non-accrual loans Non-performing loans (non-accruals plus 90+ day PD s) Provisions-to Gross Charge Offs Net Charge Offs 27 Examples: Historical Losses by Loan Segment (Pool) Historical Losses by Risk Rating Historical Losses by Transaction Size Historical Losses by Delinquency Peer Groups Benefits Increased Flexibility in Provision Amounts Easier on the Budget Demonstrates Proactive Management 28
15 Upper End of Range: ALLL based on Loan Segments 1.93% Lower End of Range: ALLL based on Risk Ratings 1.77% In Student Notebook: Sample ALLL Calculation 29 A portion of an institution s allowance for loan and lease losses (ALLL) is referred to as excess. Overly simplistic formula method. Lacking written description of processes and methodology. * Excerpts from OCC Examiner s Handbook 30
16 Follows current accounting standards Utilizes a range Includes sample loss data collection under CECL (e.g. vintage analysis) 31 Loan Segments (Pools) (CECL Model) Impaired Loans (CECL Judgment ) Qualitative Factors (CECL Judgment ) ALLL The standard does not require a specific credit loss method, allowing an organization to use judgment appropriate in its circumstances. - FASB 32
17 1.40% Auto Loan Loss Rate 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% Average Historical Loss Rate for Auto Loans = 0.65% Year 1 Year 2 Year 3 Year 4 Year % Auto Loan Loss Rate 1.20% 1.00% 0.80% 1.25% 0.60% 0.81% 0.40% 0.67% 0.20% 0.32% 0.21% 0.00% Year 1 Year 2 Year 3 Year 4 Year 5 34
18 1.40% Auto Loan Loss Rate 1.20% 1.00% 0.80% 1.25% 0.60% 0.81% 0.40% 0.67% 0.20% 0.32% 0.21% 0.00% Year 1 Year 2 Year 3 Year 4 Year 5 35 Who? ALL Banks, Bank Holding Companies, and Businesses What? Accounting Standards Update (ASU) : Financial Instruments Credit Losses (Topic 326) Immediately record full amount of credit losses that are expected. For purchased loans, allowance is added to purchase price. Does not change charge-off or non-accrual processes 36
19 Why? Recent Global Financial Crisis current model criticized for not recognizing losses until they became probable (too late) To close differences between U.S. GAAP and IFRS Also covers purchased (distressed) assets, leases, offbalance sheet items, receivables, debt securities all financial assets essentially 37 When? (Effective Dates) Publicly-owned (SEC) Banks = 12/15/2019 Other Publicly-owned Entities* = 12/15/2020 *Banks with stock traded on OTC (C-corp or S-corp) *Banks with debt securities traded by broker(s) *Potentially, Banks > $500M that have: Issued Debt Securities Larger number of shareholders *Check out ABA s Discussion Paper, Definitions of Private Company and Public Business Entity (May, 2016) All others (Privately-owned) Banks = 12/15/
20 How? Cumulative-effect, single adjustment entry to Retained Earnings with first financials after Effective Date Additional disclosures (footnotes to financials) regarding the single adjustment and subsequent methodology [goal = more transparency] Change in ALLL methodology to measure all expected credit losses based on: Historical experience Current conditions Supportable forecasts Use of [documented] judgment to determine method(s) used Can leverage existing methods & processes 39 CECL is considered the most impactful banking regulation since Dodd-Frank. - Software Company selling FASB understands that reporting organizations will incur additional costs as a result of the new ASU. -FASB 40
21 Data Collection Model Building Parallel Testing & Refinement Capital Planning & Impact Testing Ready for CECL Time frame for a Privately-held Bank : Understand CECL ABA, Webinars, State Associations, Bank Schools, Correspondent Bank, Peer Banks, GSB CLASSMATES Identify the Data Requirements What data points to collect Where to store the data Start Collecting Data NOW Key Dates (origination, default, loss1, loss2, etc.) Loan Terms (product type, risk rating and policy / underwriting exceptions at origination, at default, and at loss event) Credit Conditions (market rate for product type, [local] economic conditions at origination, at default, and at loss event) 42
22 2017: Understand, Build, and Test Forecasting Model(s) Life of Loan (LOL) CECL Model Time Frame Historical Loss Model Time Frame 2 5 Years Remainder of Life of Loan (8 20 Quarters) The biggest challenges of CECL center on the LOL loss concept, whereby credit losses expected over the life of the loan are effectively recorded upon origination. - ABA 43 Historical Loss Rate Estimate based on the past Various look-back periods Apply qualitative factor adjustments Vintage Analysis Measure based on age of loan (forecast period) Can use Historical Loss Rate + Qualitative Factor (current & expected economic conditions) beyond forecast period Develop cumulative Loss Curves for each loan pool * Asset Class used in CECL. Refers to any group of financial assets with common risk factors. 44
23 Probability of Default Analysis Losses = PD * EAD * LGD (Probability of Default) * (Exposure At Default) * (Loss Given Default) Current Basel models typically have just a 12-month forecast period More frequent back-testing required Discounted Cash Flow Modeling Based on Present Value (PV) of expected Cash Flows Interest Rate used for discounting Probability weighting is not allowed : Parallel Testing & Refinement: Choose best Methodology for your bank & the loan pool Run CECL concurrently with Current Methodology to determine differences in Provisions & ALLL level Determine how to utilize Qualitative Factors Back-test against known historical loss events or economic condition changes 46
24 2019: Capital Planning: Start funding additional provisions, if CECL indicates such is needed for cumulative adjustment Impact Testing: Test both Current Methodology and CECL using scenarios, such as: Loan Special run-up in volume Major Economic Impact causing spike in losses in particular loan pools, geographic region, etc. Across the Board change in loan volume, overall loss rates, etc. for portfolio-wide stress test of ALLL adequacy 47 Do we have to purchase software to comply with CECL? I ve heard CECL will increase our ALLL by 15-50%. Is that true? Additional CECL resources are on your Student Website for this course. 48
25 49
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