alll and the new estimate of loan losses · » a loan is impaired when it is probable that all...

ALLL and the New Estimate of Loan Losses An update on the proposed impairment model and improving the measurement of credit losses

OCTOBER 2013 MICH ARATEN, MANAGING DIRECTOR, CREDIT RISK CAPITAL ADVISORY

CHRIS HENKEL, DIRECTOR, MOODY’S ANALYTICS

2 FASB Impairment Standards and ALLL, October 2013

0%

5%

10%

15%

20%

25%

30%

35%

40%

Loan Loss Provision as % of Net Operating Revenue (all FDIC-Insured Institutions)

Provisioning for loan losses consumes a significant portion of the banking industry‟s net operating revenue

Source: FDIC

5.04%

2Q13

37.94%

5.18%


Despite the rapid provisioning during the crisis, the ratio of reserves to noncurrent loans continued to fall

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

Reserves/TL Reserves/NCL

Source: FDIC

3.51%

0.64%


Agenda

1. Brief Review of Existing Guidance

2. Overview of FASB‟s Proposed Current Expected Credit Loss Model

3. Analytical Considerations and Loan Loss Reserves

4. Stress Testing and Reserves


Brief Review of Existing Guidance 1


An appropriate ALLL, in accordance with GAAP, should reflect an estimate of probable credit losses

Estimated credit losses means an

estimate of the current amount of

loans that is probable the

institution will be unable to collect

given facts and circumstances as of

the evaluation date. Thus, estimate

credit losses represent charge-offs

that are likely to be realized for a

loan or group of loans.

- Interagency guidance, 2006


The principal sources of guidance on GAAP accounting for credit losses are FAS 5 and FAS 114

Measurement of Estimated Credit Losses

Loan Portfolio

Impaired? No

Yes

FAS 5

FAS 114

PV of

FCF

Mkt.

Price

FV of

Coll.

Segmented

Risk Pools

Unallocated

Portion of the ALLL

that is not attributed to

specific segments of

the loan portfolio


8

» Accrue an amount that appears to be a better estimate than others

within a range of estimates

» Accrual vs. Disclosure

If it is “probable” that a loss will incur and the amount can be reasonably

estimated, it should be accrued in the financial statements

If it is “reasonably possible” that a loss will incur, it should be disclosed in

the notes without recognition in the financial statements

If the possibility of loss is “remote”, disclosure is not required

ASC 450-20

Loss Contingencies

ASC 310-10

Receivables

In 2009, FASB codified the accounting standards for recognition of credit losses

» A loan is impaired when it is probable that all amounts due from a loan

are impaired

» To determine whether a loan is impaired, the institution should apply its

normal loan/credit review process

» Impairment loss = Carrying amount of the loan, less:

Fair value of the collateral (collateral dependent loans); or

PV of expected future cash flows from a loan; or

Observable market price of the loan


The incurred loss approach is believed to interfere with the timely recognition of credit losses

» It prevents banks from provisioning for an impaired asset until a “triggering

event” occurs

» Banks must wait until the triggering event has already occurred before they

recognize the loss

» By waiting, the model precludes banks from provisioning for risks the bank

can reasonably anticipate to occur

» It leads to pro-cyclicality and delayed loss recognition

» Changes in the probabilities of loss and of loss exposures should be

reflected in the ALLL

» The OCC supports FASB‟s proposed expected loss model over the current

incurred loss impairment approach

Concerns Over the Current Incurred Loss Model


Overview of FASB’s proposed Current Expected Credit Loss Model (CECL) 2


Evolution of a new impairment model

Over the last five years, the accounting community has worked to provide more

actionable information about the expected credit losses on financial assets

May 2013

Comment period ended

Evolution of Subtopic 825-15, Financial Instruments – Credit Losses (superseding ASC 310-10 (SFAS 114) and 450-20 (SFAS 5) - among others)

October 2008

Joint effort b/w

FASB and IASB to

address reporting

issues arising from

the global financial

crisis

July 2009

Financial Crisis Advisory

Group (FCAG) published

report on delayed

recognition of losses and

complexity with different

impairment approaches.

Included forward-looking

information.

November 2009

IASB published

Exposure Draft, adding

further support for a

forward-looking measure

of ECL

May 2010

FASB published a

proposed ASU to ECL

»Remaining life

»Cash flow based

»Economic conditions

remain unchanged

January 2011

FASB and IASB

published a

supplementary document

introducing “Good Book”

and “Bad Book”

distinction

July 2012

FASB and IASB jointly

released the “three-

bucket” impairment

model whereby credit

instruments would have

had different

measurement

approaches and

migration criteria across

buckets

December 2012*

FASB published the

Exposure Draft “Proposed

Accounting Standards

Update, Financial

Instruments – Credit

Losses.” Introduced the

CECL.

*Current proposal; IASB had not concluded deliberation on credit losses at the time of release

Source: FASB


The proposed accounting standards update reflects several core objectives

Objectives of the proposed update

» More timely recognition of credit losses

» Greater transparency regarding the

expected credit losses

» Improved understanding of the realizability

of assets and the inherent credit risk in the

portfolio

» Improved understanding of credit risk

changes that have taken place during the

period

» Improved understanding of purchased

credit-impaired financial assets

» Improved understanding and comparability

of interest income

» Enhanced consistency when credit

impairment is measured at the individual

asset level as compared with at the

portfolio level

Source: FASB


Working towards these standards will require a blend of judgment and empirical evidence

» The allowance for credit losses (ACL)

should be management‟s best estimate of

the PV of all contractual cash flows that

are not expected to be collected on an

asset or group of like assets as of the

financial statement date

– The timing and amount of the CFs is not

required under the new proposal

Management Judgment

Empirical Evidence

» The ECL should take into account:

– Historical loss experience (NCOs) with similar assets – need to appropriately segment

– Current conditions – prevailing credit cycle and business environment (including macroeconomic factors,

collateral values, borrower behavior, underwriting standards, etc.)

– Reasonable and supportable forecasts (**New**)

– Time value of money, either explicitly or implicitly

Source: FASB


The approach to estimating credit loss is not “one-size-fits-all,” but there are minimum requirements

» Specific approaches are not mandated but should be

consistent and appropriate for the portfolio it is

applied to

» Minimum requirements (for historical statistics):

– Consistent definition of default

– Definition of loss (i.e., amount charged off)

– Method for weighting historical experience (i.e., volume-

weighted or equal-weighted)

– Method for adjusting loss statistics for recoveries

– How expected prepayments affect the allowance for ECL

– Incorporating the time value of money

» Default probabilities and loss severities are not linear,

therefore it is inappropriate to “gross up” a one-year

measure over the remaining term

Source: FASB


Example of non-linearity of default probabilities using cumulative measures

A cumulative EDF credit measure gives the probability of default over that time period. For example, a five year

cumulative EDF credit measure of 9.64% means that that company has a 9.64% chance of defaulting over that

five year period (perhaps the remaining life of the loan).

Firm A Firm B


A common measurement approach includes the use of PD, LGD, and EAD along with credit adjustments

Performing Rated

Loans ($)

(“Pass”)

Impaired Loans ($)

(Pooled basis)

Impaired Loans ($)

(Individual)

Special Reserves

($) (Mgmt Judgment)

PD LGD Credit Risk

Adjustment

RESERVES

FOR

PERFORMING

LOANS

EL

Factor

RESERVES

FOR IMPAIRED

LOANS

Uncollected

Cash Flows

RESERVES

FOR IMPAIRED

LOANS

ADDITIONAL

RESERVES

TOTAL

RESERVES


EL = PD x LGD x EAD*

… how likely the

borrower is to go

into default

… the estimate of loss

(1-recovery) should

default occur

… the exposure

amount at the time

of default

Probability of

Default

Loss Given

Default

Exposure at

Default

= x x 3% 30¢

on the dollar

$5MM

of the $10MM

originally lent

likelihood

On average, the

amount a lender could

potentially lose

depends on three

things …

Expected

Loss

$45M

Institutions will need to estimate expected loss over the life of the loan, and also account for current conditions

*For ALLL purposes, the EAD is typically the outstanding loan amount as of the financial reporting date. A different but related reserve is held for

unfunded commitments

» These estimates will need to be further adjusted for current economic conditions and the

forecasted direction of the economy

» In addition to time horizon, another dimension for consideration is the PD measurement (i.e.,

“Point-in-Time” (PIT) or “Through-the-Cycle” (TTC))


Moreover, risk measures can be expressed in terms of “Point-in-Time” or “Through-the-Cycle”

Source: Moody’s CreditEdge

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

Median EDF for “B” rated companies

Feb. „09: 9.92%

Aug. „13: 0.31%

Median: 1.35%


Recent Developments Decisions reached to date during deliberations of CECL (through Sept. 27, 2013)

Clarifications Regarding an Entity‟s Estimate of Expected Loss

» Revert to historical average loss

experience for future periods beyond

supportable forecasts

» Consider prepayments but not extensions,

renewals, and modifications (other than

TDR)

» Recognize risk of loss, even if remote,

unless amount of loss would be zero

» Can use loss-rate models, PD methods, or

a provision matrix in addition to DCF

models

» Final guidance (TBA) will include guidance

on “reasonable and supportable

forecasts”


While CECL brings noted improvements, FASB‟s new impairment model has been met with some dissenters

» The operational impact could be significant

» Stakeholders, such as regulators,

accountants, investors, and the SEC, do not

always share a common interest

» Introduces a “life-of-loan” concept which is

said to conflict with the conceptual framework

» A forward-looking measure may be very

difficult to support the estimates

» The impact on current allowance levels

An increase of 30% to 300% to the allowance,

in addition to a potential one-time increase

At a time when banks are adding capital in

order to meet new regulatory requirements

» Favor for an alternative, such as a Banking

Impairment Model (BIM)

Commonly Expressed Concerns


How does FASB‟s CECL align with the IASB‟s proposed Expected Credit Loss Model?

Divergent Attributes

» The IASB‟s model includes three stages:

1. No significant deterioration

(12 months ECL are recognized)

2. Significant deterioration

(lifetime ECL are recognized)

3. Objective evidence of impairment

(lifetime ECL are recognized)

» The FASB CECL has no distinction for

deterioration in credit quality; all measured

at lifetime ECL

» Timing difference in the recognition of ECL

Remains a joint project between FASB and IASB, as

they work together to deliberate on comment letters

and potentially align on divergent views

Common Attributes

» Removal of the „incurred loss‟ trigger for

recognition

» Lifetime ECL are the expected shortfalls in

contractual cash flows

» An estimate of ECL will reflect the

probability that a credit loss might occur

» The estimate will be based upon use of the

same information

» The amount of ECL should be the same for

financial instruments that have deteriorated

significantly in credit quality

Note: The IASB issued an Exposure Draft, Financial

Instruments: Expected Credit Losses, on March 7,

2013. The comment period ended on July 5, 2013

Source: IIFRS and IASB


Analytical Considerations for Loan Loss Reserves 3


As previously mentioned, the ALLL consists of three distinct components

» Specific reserve for non performing loans

» Expected losses for performing loans

» Credit risk adjustment applied to expected losses


The impairment for nonperforming loans is usually on an asset-specific basis

» Asset-Specific Reserve (ASC 310-10-35/ FAS114)

» Estimate periodic cash flows and discount at contract rate of

interest.

Large exposures: Estimate on a scenario basis

Smaller exposures: Estimate conditional probability of remaining on non-

accrual, given amount of time already on non-accrual-from historical data


Considerations for estimating PD as it relates to the estimate of EL for allowance purposes

» Expected Losses= PD x LGD x EAD over contractual term

» Contractual term could be shortened based on expected

prepayment (“expected life”)

» PD could be developed from historical data associated with

current rating status incorporating transitions to other ratings

» Evaluate Expected Default Frequency (EDFs) (PIT) vs. (TTC) PDs

» Expressed as cumulative PD over expected life


Similarly, the estimate of LGD for loan loss reserving has unique attributes unto itself

» LGDs for allowance are different from LGDs for regulatory capital

» Not downturn LGDs

» Exclude workout costs

» Exclude AIR (accrued interest receivable)

» Can use overall average discount rate, possibly based on

contractual rate


There are also several treatment options for EAD

» EAD for on-balance sheet exposures = outstanding balance

» EAD for revolving credits based on unused portion

» Add Loan Equivalent (LEQ) factor to EAD

» Can either include this in the Allowance for Loan Loss Reserves

or Allowance for Lending – Related Commitments


Historical averages alone may not be sufficient, warranting a credit risk adjustment to the EL

» Historical averages may not adequately consider the current point

or forecasted direction of the economic cycle

» Credit risk adjustment modifies the base EL to reflect reasonable

and supportable forecasts about the collectability of future cash

flows

» Management evaluates the current point in the economic cycle, as

well as other important current credit indicators such as borrower

behavior and collateral values, how current underwriting

standards compare with those in the base EL, and recent trends

in economic conditions


Historical variability of PDs

Historical Rating agency data Aaa Aa A Baa Ba B Caa

Mean PD 0% 0.01% 0.03% 0.21% 1.12% 5.16% 22.56%

One Standard Deviation 0% 0.08% 0.08% 0.31% 1.11% 3.47% 16.49%

Coefficient of Variation CV= s/m) 0% 0% 200% 146% 99% 67% 73%

LEQ Distribution 6% 4% 25% 30% 20% 10% 5%

Weighted average upper bound (1s/m) 120%

Weighted average lower bound (0.5s/m) 60%


Construct scorecard

» Factors to be considered:

» Portfolio regional and industry concentrations

» Current point in economic cycle (PIT vs. TTC indicators---Credit

Edge and RiskCalc)

» Forecast of macro factors

» Underwriting characteristics of current portfolio


Apply scorecard result to range

a1F1

a2F2

a2F3

a4F4

a5F5

a6F6

EL+120%EL

EL-60%EL


Fed Reserve Survey Lending Standards

Report covers the percentage of firms surveyed who state that their

lending standards were tighter in the current quarter vs. prior quarter

-40

-20

0

20

40

60

80

100

1990Q

2

1990Q

4

1991Q

2

1991Q

4

1992Q

2

1992Q

4

1993Q

2

1993Q

4

1994Q

2

1994Q

4

1995Q

2

1995Q

4

1996Q

2

1996Q

4

1997Q

2

1997Q

4

1998Q

2

1998Q

4

1999Q

2

1999Q

4

2000Q

2

2000Q

4

2001Q

2

2001Q

4

2002Q

2

2002Q

4

2003Q

2

2003Q

4

2004Q

2

2004Q

4

2005Q

2

2005Q

4

2006Q

2

2006Q

4

2007Q

2

2007Q

4

2008Q

2

2008Q

4

2009Q

2

2009Q

4

2010Q

2

2010Q

4

2011Q

2

2011Q

4

2012Q

2

Fed Survey of Net Tightening Standards

Net(Tight-Loose) Stds Previous Qtr


Charge-offs follow tightening

0

0.5

1

1.5

2

2.5

3

-40

-20

0

20

40

60

80

100

1990Q

2

1990Q

4

1991Q

2

1991Q

4

1992Q

2

1992Q

4

1993Q

2

1993Q

4

1994Q

2

1994Q

4

1995Q

2

1995Q

4

1996Q

2

1996Q

4

1997Q

2

1997Q

4

1998Q

2

1998Q

4

1999Q

2

1999Q

4

2000Q

2

2000Q

4

2001Q

2

2001Q

4

2002Q

2

2002Q

4

2003Q

2

2003Q

4

2004Q

2

2004Q

4

2005Q

2

2005Q

4

2006Q

2

2006Q

4

2007Q

2

2007Q

4

2008Q

2

2008Q

4

2009Q

2

2009Q

4

2010Q

2

2010Q

4

2011Q

2

2011Q

4

2012Q

2

Tighter Lending Standards Lead C & I Chargeoffs by 1 year

Net(Tight-Loose) Stds Previous Qtr ChgOff Rates 1 Yr later

Adjusted R2 = 82%


Covenant quality index

» Historical information on covenant quality can also help

determining underwriting standards embedded in current

portfolio (e.g., change of control, structural subordination, cash

leakage, leveraging)

» Moody‟s covenant quality index: score summarizes protection to

bond holders ranging - CQ1 (strong) to CQ5 (weak)


Moody‟s covenant quality

3.00

3.20

3.40

3.60

3.80

4.00

4.20

4.40 Jan-1

1

Feb-1

1

Mar-

11

Apr-

11

May-1

1

Jun-1

1

Jul-1

1

Aug-1

1

Sep-1

1

Oct-

11

Nov-1

1

Dec-1

1

Jan-1

2

Feb-1

2

Mar-

12

Apr-

12

May-1

2

Jun-1

2

Jul-1

2

Aug-1

2

Sep-1

2

Oct-

12

Nov-1

2

Dec-1

2

Jan-1

3

Feb-1

3

Mar-

13

Apr-

13

May-1

3

Jun-1

3

Jul-1

3

Aug-1

3

Covenant Quality Index


Stress Testing and Reserves 4


Stress testing and Reserves

» Stress testing (CCAR) evaluates impact of macroeconomic

factors on bank profitability and on regulatory capital ratios

» Stress tests have an impact on increased PDs, accelerating

downward rating transitions, higher loss severities, and increased

likelihood of draw down on unused commitments

» Maximum losses obtained from stress tests should be

significantly above the maximum credit risk adjustment


Credit portfolio migration under stress

0

0.05

0.1

0.15

0.2

0.25

Risk Rating

1 2 3 4 5 6 7 8 9 10 Loss

Rati

ng

Dis

trib

uti

on

Credit Portfolio Migration Under Stress

Base Credit

Expected

Recession


Reserve requirement under stress

0

500

1000

1500

2000

2500

Risk Rating

1 2 3 4 5 6 7 8 9 10

Reserv

es

Reserve Requirement Under Stress

Expected

Recession


RAROC considerations

» Economic capital and risk adjusted return on economic capital

has been the guiding criteria since the mid-90s as portfolio

measurement and management have advanced

– EDF measures (CreditEdge/Credit Monitor/RiskCalc)

– Portfolio models (Risk Frontier/Portfolio Manager)

» Regulatory capital, stress tests, and liquidity measures now serve

as constraints on return on economic capital objectives

» As Loan Loss Reserve changes become implemented, care needs

to be taken that these are not part of RAROC decisions


Questions?


» Christian Henkel

Director

Moody’s Analytics Enterprise Risk Solutions

[email protected]

+1.212.553.4679

moodys.com

» Mich Araten

Managing Director

Credit Risk Capital Advisory

[email protected]

+1.914.428.6173

alll and the new estimate of loan losses · » a loan is impaired when it is probable that all...

Documents