|The graph above summarizes the losses incurred by the Big 4 banks in the years following the great recession. Some analysts have suggested that while the current Covid-19 induced recession and the Great Recession are different in may ways, this prior recession may still provide some indication of the type of losses that might occur during the current recession, if only because the two recessions share somewhat similar unemployment consequences.
The unemployment rate in June of 2020 moderated to 11.1% from a high in April of 14.7%. The unemployment rate during the Great Recession maxed out at 10.0% in October of 2009, however unemployment averaged above 8% consistently for four years from January of 2009 through December of 2012. Hopefully, losses during this recession will be much lower, assisted by the unemployment rate returning to a more moderate level much more quickly.
Significant differences in the loan portfolios of larger vs. smaller banks are a major component of the higher loss rates experienced by large banks, as is also illustrated in the NCO chart above. Using these Big 4 banks as a relative proxy for larger institutions, nearly half of all Net Charge-offs recorded during the six years following the onset of the Great Recession, were incurred on Credit Card Loans (35%) and on Consumer Loans (14%), loan types which are typically not found, or not found in concentrations, on community bank balance sheets. This single difference explains much of the difference in loss rates between larger and smaller banks. The chart also discloses that large banks also incurred significant losses on 1-4 Family residential mortgage loans and on Commercial & Industrial loan types, products which community banks share with the larger institutions.
Recommendations for Community Bankers
As the largest institutions in the country adopted CECL in Q1 2020 and in Q2 are now adjusting their rolling “life-of-loan” loss estimates under the back-drop of the Coronavirus pandemic, community bankers may well be asking themselves, what does all of this mean for me and my financial institution?
Even though community banks are not required to adopt CECL until 2020, board members, shareholders, regulators and audit firms are likely to be asking community bank leaders what the CECL impact is on your institution and will be expecting you to have knowledgeable and insightful responses to their questions. In addition, you will be taking emerging information about the effects of the current economic situation into account in setting the Qualitative Adjustment factors you are using to adjust your current loss estimates under the existing Annual Incurred Loss methodology.
CECL Model Development Activities Within Community Banks
Most community banks by now have begun to develop at least rudimentary CECL based loss forecasting models appropriate in scope to the size and complexity of their bank’s loan portfolios.
Normally included in this preparation is the collection of the necessary supporting data required to project future losses based on previous relevant experience under any of the existing CECL methodologies.
Many community banks with smaller non-complex loan portfolios will not find it necessary to go beyond deployment of some of the simpler loss forecasting methods such as the Enhanced Historical Loss Rate method, or perhaps the Weighted Average Remaining Maturing (WARM) method.
Larger community banks may also build out one or more of the more advanced CECL loss forecasting methodologies, including Vintage Analysis, Migration Analysis, Probability of Default / Loss Given Default, (PD/LGD), or the Discounted Cashflow method.
Completion of these preparatory steps establishes your community bank as well positioned for eventual CECL implementation, but more importantly, provides you with a reasonable tool with which to answer incoming questions regarding not only your institutional readiness for CECL, but also the predicted effects of CECL on your future provision expense, reserve balances and the potential impact to your bank’s capital.
Parallel Runs – CECL vs ALLL
Once your institution has collected enough historical data and has an appropriate CECL loss forecasting methodology in place, best practices indicate that you should be running parallel loan loss estimates from your CECL model and comparing these to the results of your existing ALLL results, noting the amount and location of significant differences. Each model (CECL and ALLL) should be simultaneously updated using your institutions current economic forecast.
As in the current environment, these Qualitative Adjustment factors will play a significant role in determining your final loss estimates, as has been pointed out by the experiences of the larger institutions already functioning under the CECL guidance. Performing these parallel runs once a year, or more frequently when conditions are changing materially, would be considered a minimum standard.
Loan & Capital Stress Testing
Whether your institution has a high or low degree of confidence in the accuracy of the parallel runs currently being produced by your existing CECL model, another valuable tool for assessing your institutions readiness for CECL is a Loan & Capital Stress Test.
The stress testing process normally follows the recommendations of the banking supervisory agencies Supervisory Capital Assessment Program (SCAP) and the more recent Comprehensive Capital Analysis and Review (CCAR), as is most generally applicable to larger institutions, but valuable to community banks, as well.
Stress testing your loan portfolio using a number of different potential loss rate scenarios, most of which will be in excess of the loss levels you might expect to experience based on your CECL model’s predictions, can be a very helpful exercise in assessing the impact of an underestimation in your CECL model loss forecast, or an unfavorable change in the unemployment rate or the general performance of the economy.
Much of the banking industry has already adopted CECL and many community bankers have invested time and energy in preparing for CECL’s eventual application to their institutions though the development of models, the collection of data, etc.
Both the eventual application of the CECL standard to community banks, and the accurate reporting of loan losses under currently existing methodologies in the meantime are management tasks made much more difficult by the current Coronavirus pandemic and its related economic consequences.
Community bankers wishing to remain connected to the trends impacting the industry in general must continue to be aware of the trends affecting other relevant institutions in the marketplace, be cognizant of the significant differences between those institutions and theirs, and have keen insights into their own portfolios using metrics that are consistent with industry best practices.