Posted By: TTschefke
We are considering incorporating LEP into our practice. We've found there's around a 6 month window between recognition of impairment and charge-off for our loans. If I understand it correctly, could we then multiply our historical loss rate + Q factors by 1.5 to determine our FAS 5 balance?
Correct. The Loss Emergence Period illustrates a financial institution’s estimate of the time from the point a loss is incurred to the point where the charge-off occurs. If your institution is unable to charge off loans upon impairment (what guidance recommends), then an LEP may be appropriate. As you have identified your LEP at six months, multiplying that by your FAS 5 balances would be correct. There is not an overwhelming amount of guidance on developing an accurate LEP estimate, however. One recommendation to narrow in on an appropriate LEP would be to back-test your reserve calculation pre- and post-LEP implementation. Results of back-testing could be used to justify your implementation of LEP (if the back-test confirms your prior estimates were understated). Once LEP is incorporated, back-testing will ensure consistency and gauge the accuracy of your reserve.