Jeff Judy

Jeff's Thoughts - February 6 , 2008

Take the Heat, You Can't Get Out of This Kitchen

Note: With this issue we welcome guest columnist Bill Stansifer, whom I have known and respected for more than twenty years. Bill's vast experience in credit, in staff positions and as a consultant, has given him command of both the big picture and the crucial details. He is an expert in, among other things, the analysis of loan portfolios to better predict expected losses. More on Bill below.

Provision and reserve are back on the front burner, and we are all going to feel the heat, regardless of size or history.

It's been a while, but another monumental foul up in the credit granting world got the pot going again. After the ag crisis of the early '80's, the S & L debacle of the late '80's and some lingering real estate woes in the early '90's, we'd gone a dozen years or so without any major calamity.

Could it be that memories were intact and true learning from experience had occurred? Not likely. Credit is a funny thing. In addition to the foolish, it seeks the unforeseen, the exotic. Was it really too much of a good thing -- low interest rates -- that led us back to our familiar past? Maybe, but does it matter? With enough trials of "make a judgment, take a risk," the chances of a bad outcome are statistically right at 100%. And after a long run of good outcomes like we've recently witnessed, the next bad outcome is likely to be severe. And so it is.

For community bankers, it doesn't matter that you never heard of sub-prime mortgage lending until it was in the news. It doesn't matter how dumb you think it was. It doesn't matter how obvious it was that it would result in disaster. What does matter is that you're in the same broad industry that created a global economic crisis, and the regulators that oversee this industry will respond as they must. They will vigorously push forward the methods they began fostering during the S & L years. They will insist on sound analysis and consistent process for determining reserve adequacy. Whether they're talking about Basel II or plain old common sense, you will listen.

Bankers and their regulators approach these two key items, provision for loan loss on the income statement and loan loss reserve on the balance sheet, very differently. Regulators always look first at the reserve, because they are charged with ensuring soundness, which shows best through a strong balance sheet. Once you've locked in an appropriate reserve, provision follows by simple math.

Bankers, on the other hand, have traditionally viewed provision as a line item on the income statement that offered a little, shall we say, wiggle room. Do you think the consistency of earnings, period to period, that big and small banks alike have touted as testament to their astute management happened by accident? We all know where the fine tuning took place.

That kind of fine tuning is, for all practical purposes, over. Oh, you will still be able to tune your income statement, maybe not as finely as before. But you will have to know what the expected losses inherent in your credit decisions are with much more accuracy.

Then, the expected loss inherent in your booked portfolio will come as no great surprise when you analyze the adequacy of your reserve and take provision accordingly.

How are you going to do that? The answer is probably more straightforward than you think. You need to know what your own experience and behaviors have produced in the way of past loan losses. You need to know this with precision and with (a currently overused buzz word) "granularity."

The loan loss reserve must reflect expected losses for the remaining life of your pool of loans. After all, you're ostensibly displaying the true value of your loan portfolio when you net it against your loss reserve. ("I reserve for two years of installment loan losses" does not constitute analysis.) You will need to be true to FAS 5 (pools of loans) and FAS 114 (large problem loans).

And to determine your own expected loss, your first and most fundamental need is data, correct and complete data, automated and systematic data. Start saving it now. Save it in a proper format every month. Save it even if you don't know exactly how you're going to use it. By the time you figure that out, you'll already have some good data.

Saving data is more tedious than it is complicated. It will, of course, require some systems resources and expertise. If necessary, get some outside help to get started, to collect and hold the data (scrubbed of individual identifiers), and to perform the analysis.

Above all else, don't delay. Don't give yourself the excuse that you don't know exactly how you're going to analyze the data.

With provision and reserve back on the front burner, start saving all the usable data you can. Do it now.

About Bill Stansifer

Bill Stansifer's banking experience includes his role as Credit Policy Officer for the Community Banking Group at Norwest (pre Wells Fargo) and a stint as Chief Credit Officer for FirstMerit Corporation, a $10 billion regional holding company based in Akron, Ohio. Bill later fled the corporate world to try his hand at some real commerce.  He has stumbled back from that foray to do some consulting for community banks and some teaching (banking) in Vietnam.  Bill loves data, and he especially loves loan migration analysis.  He hides out in Amish country in northeastern Ohio where he can be reached by e-mail at .