Conversations about the Federal Accounting Standards Board'srecent proposal to replace its current Allowance for Loan and LeaseLoss model with one that includes “expected credit loss”measurement actually began in 2008.

In the intervening years, many credit unions found their creditloss forecasts to be inaccurate and saw loan loss reserves playing“catch-up” as actual loan loss experience tended to be a laggingmetric. Moreover, when the tides turned on delinquencies andlosses, the historical loan loss experience models suggested thatcredit unions continue to add to their reserves when in fact thereserves where already more than sufficient.

Irrespective of the final version of the FASB proposal thateventually comes to pass, the current conversation focused on“expected credit loss” provides a great opportunity for creditunions to begin the process of re-evaluating their loan lossreserve methodologies.

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Specific in this re-evaluation should be the inclusion oftechniques and technologies that provide better forward focusedloss forecast tools. To provide some perspective, a briefreview of the techniques and technologies currently in use iswarranted.

During the recent economic downturn, many organizations' lossforecasting models and reserve methodologies relied heavily uponhistorical loss experience and traditional (and prevalent) creditscoring models that use an individual's past payment habits as apredictor of future payment tendencies and, in turn, potentiallosses.

As economic conditions improved, organizations realized thatdepressed credit scores were not necessarily translating intolosses requiring reserves. Because of this, someorganizations began to incorporate other factors like change inunemployment rates, changes in real estate values, etc. asenvironmental factors to offset the “false high” being suggested bythe existing credit scores.

The challenge embodied with this approach to loss forecastingand reserve methodology is that it is heavily dependent onhistorical loss experience and bureau credit scores that arebackward indicators. These timing differences naturallyintroduce the opportunity to be under or over reserved depending onthe portion of the economic cycle that presently exists.

Moreover, none of these metrics speak directly to a borrower'sincome and the stability of their income which are the true driversof consumers' future ability to pay and creditworthiness. Aswas clearly demonstrated during the recent economic downturn, it isthe presence of a steady income stream, and not credit scores, thatrepay a loan on a monthly basis.

To respond to these identified weaknesses, new innovativescoring models have been developed that are much more forwardlooking and include a measurement of a borrower's incomestability. The genesis for these scores came from arelatively interesting but pretty straightforward observation thatin a poor economy, unemployment increases and the affectedborrowers tend to lose their income and their ability to pay, andconsequently become delinquent (and cause losses) at a much higherrate. Research also showed that borrowers tend tofall behind on their payments when they work in industries orlocations that are not doing well, even if the overall economy isdoing OK. And by using credit scores that offer superior forwardindication of borrowers' credit risk, credit unions will be able toimprove the accuracy of their forecasted expected losses.

While the final version of the FASB proposal concerning reservemethodology is still months away, with the required implementationdate likely several months after that, introducing these new creditscores into your organization today makes a lot of sense. Asan initial strategy, these scores could be applied to your overallportfolio and the results used instead of traditional credit scoreswhen calculating credit losses and loan loss reserves.

Comparing the results of the traditional loan loss reservecalculation to the new score loan loss reserve calculation can helpyou size the risk or opportunity your organization faces from theproposed changes to FASB allowance methodology.

With this knowledge as a backdrop, the next opportunity forusing these new scores relates to their use in the underwriting ofnew loan requests. Given the forward looking nature of thesescores, using them to originate new loans today will help yourorganization to react to the opportunity/risk that it haspreviously identified.

For example, if the comparison of results from the traditionalscore versus new score allowance methodology suggests that yourorganization's reserve position will be more than adequate toabsorb the “expected credit loss” requirements suggested by theproposed FASB revisions, using these new scores to help expand yourorganization's lending window may be appropriate.

Conversely, if the reserve analysis suggests that yourorganization may need to add to its reserves under the new FASBrequirements, using these new scores to help contract your lendingwindow will help your organization ease into the new reserveenvironment.

The comment period (which expires April 30, 2013) of theproposed FASB changes related to reserve methodology gives yourorganization a window of opportunity to evaluate the potentialimpact of these changes before they actually take effect.

Key to this evaluation will be the use of the new and innovativescores that help to prospectively size “expected creditloss”. With the information provided through the use of thesescores, the comments you choose to provide to FASB can be morerelevant and can carry greater weight in attempting to change keyaspects of the proposed revisions.

JimSimon is the president of Akcelerant Advisors LLC in Malvern,Pa.