Assessing credit risk & ALLL levels under an expected credit loss model

Mar 12, 2015

credit risk policies and procedures


Assessing credit risk comprises many components. Many of the fundamental principles will remain unchanged upon the release of FASB’s CECL model; however, accounting for expected credit losses WILL undoubtedly introduce new policies and procedures into financial institutions’ methodologies for assessing credit risk and allowance levels.

The Basel Committee on Banking Supervision (BCBS) released a consultative document in early February that details the supervisory expectations for transitioning to an expected loss model. In the Basel document, among other things, the Committee provided a list of criteria for assessing credit risk and measuring allowance levels. According to the Basel Committee, a robust and sound methodology will, at minimum:

(a) include a robust process that equips the bank with the ability to know the level, nature and components of credit risk upon initial recognition of the lending exposure to ensure that subsequent changes in credit risk can be tracked and determined;

(b) include criteria to duly consider the impact of forward-looking information and macroeconomic factors. Whether the evaluation of credit risk is conducted on a collective or individual basis, a bank must demonstrate that the assessment and measurement of ECL goes beyond considering historical and current information, so that the recognition of ECL is not delayed. Such criteria should result in the identification of factors that affect repayment, whether related to borrower incentives, willingness or ability to perform on the contractual obligations, or instrument terms and conditions. Macroeconomic factors relevant to the assessment may be at the international, national, regional or local level;

(c) include, for collectively evaluated exposures, a description of the basis for creating groups of portfolios of exposures with shared credit risk characteristics;

(d) identify and document the ECL assessment and measurement methods (such as a loss rate method, migration analysis, probability of default (PD)/loss-given-default (LGD) method, or other) to be applied to each exposure or portfolio;

(e) document the steps performed to determine that the selected method is most appropriate, especially if different ECL measurement methods are applied to different portfolios and types of individual exposures. A bank should be able to explain to its supervisors the rationale for any changes in measurement approach (eg move from a loss rate method to a migration or PD/LGD method) and quantitative impacts of such changes;

(f) document the inputs, data and assumptions used in the allowance estimation process (such as historical loss rates estimates and economic forecasts), how the life of an exposure or portfolio is determined (including how expected prepayments have been considered), the historical time period over which loss experience is evaluated, and any qualitative adjustments. Examples of factors that may require qualitative adjustments are the existence of concentrations of credit risk and changes in the level of such concentrations, increased usage of loan modifications, changes in expectations of macroeconomic trends and conditions, and/or the effects of changes in underwriting standards and lending policies;

(g) include a process for evaluating the appropriateness of significant inputs and assumptions into the ECL measurement method chosen. The Committee expects that the basis for inputs and assumptions used in the estimation process will generally be consistent period to period. Where inputs and assumptions change, the rationale should be documented;

(h) identify the situations that would generally lead to changes in ECL measurement methods, inputs or assumptions from period to period (eg the conditions when the time horizon over which expectations are to be formed would change; or the conditions under which an exposure originally monitored on a collective basis would be removed from the group for individual assessment);

(i) consider the relevant internal and external factors that may affect ECL estimates, such as underwriting standards and industry, geographical, economic and political factors;

(j) address how ECL rates are determined (eg historical loss rates or migration analysis as a starting point, adjusted for current conditions, forward-looking information and macroeconomic factors). A bank should have a realistic view of its lending activities and consider forwardlooking information that is reasonably available, macroeconomic factors, and the uncertainty and risks inherent in its lending activities when estimating ECL;

(k) identify what factors are considered when establishing appropriate historical time periods over which to evaluate historical loss experience. A bank should maintain sufficient historical loss data over at least a full credit cycle to provide a meaningful analysis of its credit loss experience for use as a starting point when estimating the level of allowances on a collective or individual basis. An entity should adjust estimates of ECL based on historical data, for current conditions and forecasts of future conditions that did not affect the period on which the historical data is based;

(l) consider the appropriateness of historical data/experience in relation to current conditions, forward-looking information and macroeconomic factors, and document how management’s experienced judgment is used to assess and measure ECL;

(m) determine the extent to which the value of collateral and other credit risk mitigants incorporated in the lending agreements affect ECL;

(n) outline the bank’s policies and procedures on write-offs and recoveries;

(o) require that analyses, estimates, reviews and other tasks/processes that act as an input or output to the credit risk assessment and measurement process are performed by competent and well trained personnel who are independent of the bank’s lending activities. The inputs and outputs from these functions must be well documented, and include clear explanations supporting the analyses or rationales;

(p) document the methods used to validate models used for ECL measurement (e.g., backtests);

(q) include a top-down analysis to measure collective allowances when forward-looking information and macroeconomic factors cannot be factored in on an individual basis. This will require that a bank use its experienced credit judgment to consider broad trends in the entire lending portfolio, changes in the bank’s business model, macroeconomic factors, etc; and

(r) require a process to assess the overall adequacy of allowances in accordance with the relevant accounting requirements.