Conversations about the Federal Accounting Standards Board’s recent proposal to replace its current Allowance for Loan and Lease Loss model with one that includes “expected credit loss” measurement actually began in 2008.
In the intervening years, many credit unions found their credit loss forecasts to be inaccurate and saw loan loss reserves playing “catch-up” as actual loan loss experience tended to be a lagging metric. Moreover, when the tides turned on delinquencies and losses, the historical loan loss experience models suggested that credit unions continue to add to their reserves when in fact the reserves where already more than sufficient.
Irrespective of the final version of the FASB proposal that eventually comes to pass, the current conversation focused on “expected credit loss” provides a great opportunity for credit unions to begin the process of re-evaluating their loan loss reserve methodologies.
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Specific in this re-evaluation should be the inclusion of techniques and technologies that provide better forward focused loss forecast tools. To provide some perspective, a brief review of the techniques and technologies currently in use is warranted.
During the recent economic downturn, many organizations’ loss forecasting models and reserve methodologies relied heavily upon historical loss experience and traditional (and prevalent) credit scoring models that use an individual’s past payment habits as a predictor of future payment tendencies and, in turn, potential losses.
As economic conditions improved, organizations realized that depressed credit scores were not necessarily translating into losses requiring reserves. Because of this, some organizations began to incorporate other factors like change in unemployment rates, changes in real estate values, etc. as environmental factors to offset the “false high” being suggested by the existing credit scores.
The challenge embodied with this approach to loss forecasting and reserve methodology is that it is heavily dependent on historical loss experience and bureau credit scores that are backward indicators. These timing differences naturally introduce the opportunity to be under or over reserved depending on the portion of the economic cycle that presently exists.
Moreover, none of these metrics speak directly to a borrower’s income and the stability of their income ‒ which are the true drivers of consumers’ future ability to pay and creditworthiness. As was clearly demonstrated during the recent economic downturn, it is the presence of a steady income stream, and not credit scores, that repay a loan on a monthly basis.
To respond to these identified weaknesses, new innovative scoring models have been developed that are much more forward looking and include a measurement of a borrower’s income stability. The genesis for these scores came from a relatively interesting but pretty straightforward observation that in a poor economy, unemployment increases and the affected borrowers tend to lose their income and their ability to pay, and consequently become delinquent (and cause losses) at a much higher rate.
While the final version of the FASB proposal concerning reserve methodology is still months away, with the required implementation date likely several months after that, introducing these new credit scores into your organization today makes a lot of sense. As an initial strategy, these scores could be applied to your overall portfolio and the results used instead of traditional credit scores when calculating credit losses and loan loss reserves.
Comparing the results of the traditional loan loss reserve calculation to the new score loan loss reserve calculation can help you size the risk or opportunity your organization faces from the proposed changes to FASB allowance methodology.
With this knowledge as a backdrop, the next opportunity for using these new scores relates to their use in the underwriting of new loan requests. Given the forward looking nature of these scores, using them to originate new loans today will help your organization to react to the opportunity/risk that it has previously identified.
For example, if the comparison of results from the traditional score versus new score allowance methodology suggests that your organization’s reserve position will be more than adequate to absorb the “expected credit loss” requirements suggested by the proposed FASB revisions, using these new scores to help expand your organization’s lending window may be appropriate.
Conversely, if the reserve analysis suggests that your organization may need to add to its reserves under the new FASB requirements, using these new scores to help contract your lending window will help your organization ease into the new reserve environment.
The comment period (which expires April 30, 2013) of the proposed FASB changes related to reserve methodology gives your organization a window of opportunity to evaluate the potential impact of these changes before they actually take effect.
Key to this evaluation will be the use of the new and innovative scores that help to prospectively size “expected credit loss”. With the information provided through the use of these scores, the comments you choose to provide to FASB can be more relevant and can carry greater weight in attempting to change key aspects of the proposed revisions.