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PCBB Banc Investment Daily February 09, 2015
Banc Investment Daily
February 09, 2015

Angry Hippos And ALLL

There is a video that has been making the rounds of an angry hippo chasing a safari boat on a river in Botswana. Its enormous mouth snaps just out of reach of the people in the boat. You see, hippos are territorial and the boat had ventured too close to its happy home, thus provoking the attack. Hippos are often portrayed as cute, pudgy awkward animals in cartoons, but in reality they are highly aggressive and quite agile. They move particularly fast in water, despite weighing around 6K pounds and even on land they can run at 14mph - about as fast as an average human can sprint for a few yards. Given these odds, we won't be challenging any hippos to a footrace.
At this moment, there are new rules regarding the calculation of ALLL charging towards us like an angry hippo. We bring this up because unprepared banks may find themselves staring into the open mouth of regulatory difficulties. For most bankers, given the impact to earnings and performance, calculation of the allowance for loan and lease losses is allocated significant time and effort. There is extensive analysis, reporting and documentation required and during the financial crisis, inadequacies were at times enough to bring down a bank. Most banks have upgraded their process since the crisis, but now there is a new set of rules coming fast with the FASB current expected loss model (CECL).
For now, the CECL rules are still being finalized, but it is estimated that many banks will need to increase their allowance in the end. This comes at an interesting time in that many banks are being encouraged by external auditors to reduce allowance levels based the decline of credit problems in portfolios over the last few years. Regulators on the other hand, generally want reserves kept high and this is at least in part due to the expectation that CECL will require a larger allowance.
At a base level, CECL differs from past calculation processes in that it looks at the value at risk over the life of the loan. The new calculation also considers normal and scheduled principal reductions, additional principal reductions (like prepayments) and the present value of future loss expectations. This forward look also takes into consideration economic factors like interest rates and the duration of economic cycles. That is a huge change against the old "standard" of 1.50% in the good old days.
The current economic expansion measured by GDP growth is moving towards the longer end of a typical expansionary cycle. This has regulators concerned that a downturn may not be too far in the future, if history is used as a guide. If credit problems arise at the same time CECL calculations require a larger allowance, many banks would find it difficult to fill the hole.
There are things a bank can do to prepare for CECL, especially in terms of gathering better data. Start by considering expanding homogenous loan classifications and understanding that call report classifications may not suffice. Methodologies should include grade migration to charge-off and default. If possible, data from the last economic downturn should also be included. In addition to a more forward-looking method of calculation, regulators want to see model validation, even if the bank is using an internal model. Many banks in the end may find that their current ALLL process is not robust enough for CECL, so they may have to rethink things from the ground up.
By updating current processes, adding new granularity and gathering more data now in preparation for the new rules, you should manage to keep the angry hippos away from your bank.