The importance of documenting the PD/LGD method

Sep 24, 2015

The probability of default/loss given default (PD/LGD) method for estimating loss rates is not as commonly used by banks and credit unions in determining the allowance for loan and lease losses (ALLL) as are other methods, such as historical loss and migration analysis.

Nevertheless, some larger financial institutions use the PD/LGD method for FAS 5 loans, and even banks that aren’t among the largest in the U.S. are considering a move to this option due to expected implementation of expected credit loss accounting models, such as the FASB’s current expected credit loss model, or CECL.

In fact, a 2014 poll among participants of an Abrigo webinar on loss methods, found that while only 7 percent of respondents were using PD/LGD at the time, one in five institutions represented on the webinar indicated a desire to transition to the method within a year. PD/LGD builds on default probabilities already incorporated into an institution’s risk rating process by utilizing industry- or segment-specific loss rates to calculate the expected loss. This granularity on losses and comprehensiveness of the estimate are among the attractions of the method.

But for banks and credit unions that shift to PD/LGD, documentation of the methodology will be especially important, considering the dearth of easy-to-understand regulatory guidance on the method and the scrutiny regulators will provide to financial institutions’ loan-loss estimates.

“A lot of people don’t understand what the guidance specifically says,” according to Emily Bogan, senior risk management consultant at Abrigo. “In addition, many people have different ways of defining or measuring some of the inputs to the PD and LGD components.”

What Basel says about documentation

The Basel Committee on Banking Supervision (BCBS) in early 2015 issued guidance on sound credit risk practices associated with the implementation and application of expected credit loss accounting models, and this guidance provides important insight into regulators’ expectations related to documenting the PD/LGD method or any other method for estimating losses.

For example, Basel notes that “a robust and sound methodology for assessing credit risk and measuring the level of allowances” will identify and document the methods applied to each exposure or portfolio when assessing and measuring expected credit loss, or ECL.

Documenting the steps that the financial institution used to determine that its selected method is the most appropriate is also recommended, especially if different methods are applied to different portfolios and exposures. “A bank should be able to explain to its supervisors the rationale for any changes in measurement approach (e.g., move from a loss rate method to a PD/LGD method) and quantitative impacts of such changes,” the guidance says.

A third piece of guidance is that inputs, data and assumptions used for the probability of default/loss given default method should be documented. For example, documentation should include how the institution determined the life of an exposure or portfolio, including how expected prepayments were factored in. Default probabilities and the loss rates tied to defaults may vary from industry to industry, product to product or time period to time period, and documenting those variations and assumptions behind them could make it easier to address any questions regulators have when reviewing loss estimates.

In addition, the Basel guidance suggests regulators will want to see:

“The development of ECL estimates is a process that is influenced by many factors,” the Basel document states. “Given that management and users have differing objectives, it is imperative that the inputs to management’s credit risk assessments and ECL estimates are well articulated and understood. The Committee expects quantitative and qualitative disclosures, taken together, to provide a clear picture to users of the main assumptions used to develop ECL estimates, and the sensitivity of ECL estimates to changes in those assumptions.”

Finally, the Basel guidance suggests that financial institutions document how they have validated the PD/LGD method. In other words, backtesting by periodically re-evaluating loss horizons and loss-measurement methods should be part of the institution’s processes, and those processes should be well documented.

“Institutions should take special care to document the research behind loss rates and to be sure to periodically review those loss rates and their loss horizons,” said Bogan.

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