Jeff Judy

Jeff's Thoughts - October 23, 2013

FASB Standards Ruling: "Expected Loss" and Ensuring Capital Adequacy

I have been writing regularly on the coming FASB Standards Ruling. (I'll provide links to the previous three Jeff's Thoughts articles on this topic below, in case you missed any of them or would like to review them together.) This ruling will be probably be implemented in the next quarter or two, and it will force a significant shift in how your bank reports the state of your credit portfolio, and on the financial protection your institution must have in place to deal with problems.

The "big picture" change is that banks will have to shift from describing the current state of the portfolio ("incurred loss") to predicting the future state of the portfolio ("expected loss"). Most banks will want to update the models they use to forecast expected loss, and to manage reserves to cover those expectations.

Naturally, the Allowance for Loan Lease Losses (ALLL) is intended to be the backstop for expected loss. Careful credit portfolio assessment and forecasting will guide the bank in managing ALLL to provide adequate resources to respond to reasonably predictable losses, walking a fine line between sufficient reserving and locking away more resources than is necessary.

But those expected loss forecasts and ALLL levels ultimately have an impact on Capital adequacy. After all, "expected loss" implies "unexpected loss" and that's part of the new language as well. If all your expected losses come to pass, they will drain ALLL, leaving you only with Capital to handle any unexpected losses that may pop up above and beyond what you predicted and prepared for.

Capital is the ultimate backstop to total credit loss, expected and unexpected. It is, really, the last resort. Just as the combination of seat belts and air bags protects you from catastrophic events in your car, ALLL and Capital work together to protect your bank against catastrophic credit losses.

That means that if your expected losses are understated, your reserves will be exhausted when the actual losses hit. And then your "air bag" -- Capital -- will deploy prematurely. That could happen because your model is not accurate enough, but it also happens when bank management makes the decision to be conservative with expected loss management, to use the lowest numbers possible, whether to impress stockholders or free resources or for whatever reason.

Whatever the root cause of understating expected losses, with no ALLL left to draw upon, you'll end up eating Capital to cover those losses, and that has multiple consequences.

First of all, Capital adequacy has, as you well know, been squarely in the crosshairs of the regulators ever since the economic downturn. Being forced to tap Capital to address credit losses is about the fastest way you can find to draw the scrutiny of regulators.

Secondly, if you are already tapping Capital to handle losses that should have been expected, when those unexpected losses pop up, you won't have enough "air bag" left to protect you from the impact. That could mean joining a long list of institutions, in recent years, who have found their business journeys ending rather abruptly.

I am not suggesting you go ultra-conservative and over-reserve. Locking away more resources than are needed in ALLL limits your opportunities for growth, and your flexibility to respond to conditions and to opportunities in your marketplace.

I am suggesting that moving to "expected loss" is anything but a "tweak" in the standards, nor is it just one isolated item. The chain of events from expected loss to ALLL to Capital to unexpected loss can produce, at best, a lot of regulatory hassle, and at worst, devastating consequences if you don't get the first item in the chain, expected loss, right.

That is why it is clearly time to take a fresh look at how you do your credit portfolio assessment.