C. Myblog

Aggregating Risks To Net Worth—The Credit Risk Component

December 16, 2011

During a recent education course, we fielded the following question:  “How do you develop a proxy for a worst-case loan loss assumption when aggregating risks to net worth?”

This is a great question and it stimulated lively discussion.  While there is not one right way, the following method has been valuable in developing concentration risk limits designed to address credit risk.  This method looks back over a specified timeframe (a common, initial look-back is 5 years) and identifies the 6- or 12-month period that experienced the highest annualized loss rate for each loan category.  Each rate is then applied to the current balance of each respective loan category and totaled to come up with the dollars for the total worst-case loan loss assumption.  Frequently, a factor is added to answer, “what if we had to absorb losses beyond our worst historical experience?”  Common factors include increases of 33%, 50%, or even 100% above the worst historical experience.

With many credit unions having just come out of their worst credit loss experiences in memory, this method captures and utilizes the information gained during that environment.  This method is easily reproducible on a periodic basis and can be re-evaluated annually to ensure that the risks are sufficiently captured.  As time progresses, and as loss histories for various loan categories continue, the loss rates may need to be adjusted to account for new loss experiences in order to keep the spirit of capturing a “worst-case” environment.  This process will help to ensure that a credit union’s management and board do not lose sight of the credit union’s worst credit loss experiences.

Whether or not the above methodology is utilized, one thing is abundantly clear—documenting the rationale behind a worst-case loan loss assumption is an absolute must!

Comments
  • Gregg Stockdale

    One is reminded of what Einstein said – Not everything that is important can be measured and everything that can be measured isn’t necessarily important. I think we are seeing the latter part of that. If we “worse cased” everything… we’d never get out of bed (if we were even brave enough to own one, given the risks). NCUA has gone overboard with their 400 and 500 shock tests. Someone will have to tell me how to negative shock 1% by 500 BP. (Dear member, you can put money on deposit here for a mere 4% fee each year for the privilege of us holding your funds).

    My point – We need to get back in the business of MANAGING risk, not AVOIDING it. When we start to look at worse case…. the next step on that slippery slope is to do nothing. EVERYTHING becomes too risky.

    Don’t fall for the regulators over-reaction to their long term inaction. They have egg on their face for letting the debacle we are living through happen (and for good reason). Now they are in the over-control mode. Don’t let them do that. It’s like their standard answer to a thin bottom line – control costs… NO WAY!!! Concentrate on generating more INCOME.

    We got here by taking too much risk. We need to take some risk to move forward and get out of this mess. Concentrating on worse case is the wrong way to move forward.

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