Jeff Judy

Jeff's Thoughts -July 31, 2013

FASB Standards Update: The Meaning of "Expected"

In a recent article in Jeff's Thoughts ("Change the Language, Change the Industry"), I introduced the proposed FASB Standards Update related to, among other things, focusing on "expected loss" rather than "incurred loss." This is a significant change in the way we will have to think about credit, especially at the portfolio level. And it is a change that will impact all levels of the industry, being applicable to any FDIC insured institution.

Frankly, I think it would be easy to under-react to this change. The first mistake that some banks will make is to treat this as merely a change of terminology. It is much more than that. It is a change in philosophy, one that will demand new analysis models, different use of data, and a keen sensitivity to how the regulators interpret "expected loss."

The second mistake some banks will make will be to take too narrow an approach to forecasting loss. Banks already deal with expected losses in their forecasts for their more problematic loans. Credits that make it to the watch list, or that get extra attention on their way to the watch list, are known to be likely to produce chargeoffs.

But the total expected loss will include a certain number of surprises, meaning that some supposedly solid credits will go bad. This is the classic insurance situation, the actuarial approach. Your insurance company knows that a certain number of supposedly very healthy people will drop dead, and that a certain number of very safe drivers will have serious accidents. They know what those numbers are, they just don't know how to identify those mishaps at the individual level in advance.

In other words, those claims are surprises in the sense of "who", but otherwise, they are provided for. They manage this by taking a "portfolio of risk" perspective, in a sense.

Bankers, on the other hand, can get so locked in on individual relationships that they find it hard to believe that their good customers will go astray. That can lead to underestimating expected loss. Even if you don't know which credit will go bad, from your best risk pools, you will have to account for the probability of problems in those pools in your expected loss figures.

The third mistake that will lead to underestimates of expected loss is wimpy "what if" analysis. Forecasts need to realistically consider possible future conditions. After all, not too long ago, a lot of bankers believed that home property values could only go up, never down, so they didn't have a "what if" for that. Guess how that turned out ...

The fourth mistake many institutions will make is underestimating how tuned in the regulators will be to "expected loss" and "what if" modeling. After all, stress testing -- which is basically running your model with "what if" parameters -- is getting a lot of attention, and will be required of smaller and smaller banks. And in any case, it is "in the air" the regulators breathe these days, so they'll be interested in whether your forecasts of expected loss are real world -- meaning their world -- enough to meet the standards.

This will be a profound shift in how our industry operates. It is by no means too early to start reviewing your practices, your data collection and analysis tools, and your own standards for credit portfolio assessment if you want to make this transition as efficiently as possible.