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FASB ALLL Proposed Rule Change

FASB’s proposed rule change on how to account for credit losses has stirred up a lot of conversation, as well as concern, among many financial institutions, trade groups and agencies, including the NCUA. While not final, the rule would essentially change the current historically based method of calculating loan losses, and replace it with a forward looking expected loss model. The details of the proposed rule can be found by clicking here.

Whether or not you agree with the proposed rule, it’s never too early to begin considering how it could impact your credit union if implemented. Consider taking some time with your management or ALCO to think through some of the possible consequences this rule could have, and how your credit union might respond. For example, how might it impact future lending decisions? How will earnings and net worth be impacted once the rule is implemented?

Even if the rule is never implemented, the strategic thinking process is not a futile effort. Many credit unions find great value in taking the time to complete this kind of exercise. However, if the rule is in fact implemented down the road, your credit union will have a head start on understanding what the impacts might be and how to respond.

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Aggregating Risks To Net Worth—The Credit Risk Component

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!

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Do Lower PLL Ratios Mean The Credit Crisis Is Over?

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On the surface, recent credit union provision for loan loss (PLL) trends seem encouraging; industry-wide through second quarter 2010, the ratio of PLL to average assets has declined by 31 basis points to an annualized ratio of 0.81%.  However, delinquencies and charge-offs as a percent of loans have only decreased by 11 basis points and 5 basis points respectively for the same period.
Of course every situation and institution is unique, but as we look toward 2011, credit unions might want to consider:

  • Is the improvement in PLL sustainable?  Or, could it be a function of allowance accounts being over-funded?  As noted above, recent delinquency and charge-off trends do not look as positive as the industry PLL trend
  • Do the unemployment outlook, real estate values and the trends in member credit scores support the assumption that PLL will continue to decrease through 2011?
  • What if many of our usually dependable borrowers lose their jobs and, at a certain point, run out of savings?
  • What if strategic defaults become more commonplace?  Consider that strategic defaults are currently blamed for as much as 25% of foreclosure activity
  • Could commercial real estate woes trickle down to further impact the economy and cause broader loan losses?

Is 2011 the year that we’ll see sustainable improvements in PLL?  Hopefully it is, but with all of the uncertainty out there, we may not want to count on it just yet.

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Prolonged Low Rate Environment?

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For months many have been watching and wondering when the inevitable increase in market rates might materialize.  Now, with some economists projecting that rates will stay at historic lows for another 12-18 months, credit unions should evaluate how, or if, they can continue to maintain net interest margin and ROA.

Not all institutions have room to lower deposits enough to mitigate the continued erosion in the yield on assets.  In a sense, deposit pricing is reaching a “floor” for many credit unions.  All else being equal, ROA will continue to erode and interest rate risk profiles will weaken as higher-rate loans and investments roll off, being replaced with lower yielding assets.

So what should credit unions do?  Common strategies include looking beyond the margin and evaluating expenses, as well as potential new sources of non-interest income.  As mentioned in previous posts, some institutions are stretching for yield, either in loans or investments.  If this strategy is employed, institutions need to carefully monitor the impact on the risk profile, and make sure decisions are tested beforehand and fit within the credit union’s philosophy and A/LM policy/guidelines.

Finally, some institutions have chosen to not take any drastic steps at this time, and have instead begun to adjust expectations at both the employee and board level, re-evaluating what success looks like in this environment.  One potential saving grace is that loan losses seem to be stabilizing in many areas, but should not be taken for granted given what institutions have experienced over the last two years.