Community banks can no longer estimate their loan loss reserves the way they did before the coronavirus upended the global economy. But there’s a solution, as this article explains.

Think back to January. Your bank had finished another great year, and you had to calculate your ALLL for year-end financial reports. You had a model, but the results of the model simply weren’t large enough. Even if you are an SEC-filer getting ready to comply with CECL, you discovered that CECL didn’t really solve this “problem.” The losses just weren’t there.

You couldn’t file a reserve of 15 basis points – your auditors, regulators, shareholders and board of directors would certainly have something to say if you did. The optics weren’t quite right. So, you looked to “Qualitative Factors.” Q-factors are a normal, acceptable part of any reserve – and they have their place. No model can know everything. In your case, Q-factors made up 85% of the reasoning behind your reserve (85 basis points of your 100 basis-point-reserve). You filed your numbers and began to get ready for another great year.

But now it’s April. The first quarter is over. It’s time to nail down the reserve. COVID-19 has caused certain aspects of the economy to come to a complete halt and more bad news may be on the way. You haven’t yet incurred any new losses and your existing ALLL or CECL model is showing you the same 15 basis points it did in 2019Q4. You know your reserve needs to increase, and the Q-factors must do the work. You just don’t know how…

Dealing with Uncertainty

A few weeks ago, we wrote about how Community Bank ALLL reserve rates were going to increase due to the COVID pandemic, even if CECL wasn’t in effect.  We don’t yet know how much of an increase there will be (public filings for Q1 aren’t due yet and banks were given a 30-day grace period). But we do know that banks are struggling to find the right adjustment to make and how to quantify and justify it, using either their incurred loss or CECL model. Many of our clients have asked how to approach this conundrum given the current economic situation.

The pandemic has created a situation of massive uncertainty. We will likely see a sharp contraction in GDP and spike in unemployment in the first and second quarters.  While it’s virtually impossible to know how long this situation will last and how much damage it will ultimately inflict on loan portfolios, there is a logical starting point.

And that gets us to stress testing, a powerful tool to address this problem.

We talk about stress testing quite a bit around here. And the message has been consistent since the early days:  A stress test is not a check-the-box exercise. Rather, it is a tool that can be used to inform many facets of critical bank operations, including the ALLL (or ACL if you are using CECL). A proper stress test demonstrates how a period of economic distress would affect your loan portfolio without specifying how that period of economic distress occurs. It could be another housing crisis, the burst of a bubble, or even a global pandemic. Stress tests are used to estimate unexpected losses. But what happens when today’s economy resembles today’s stress test? Unexpected losses become expected losses.

Let’s walk through a simplified example.

The table below presumes that the likelihood of a severely adverse case economic recession has increased as of the end of March versus the end of last December. It is simple example, meant to illustrate a point.

Stress Testing is a Powerful Tool

This is a tried and true approach. For years, many of our clients have successfully utilized their stress test results to augment their ALLL calculation by quantifying their economic qualitative factors. This method provides two important things: a starting point, and a direction. Whether CFOs want to admit it, much of the Q-factors in past reserves have lacked those two critical components. With a starting point, you can begin to understand the magnitude such an event may have on your reserve. With a direction, you can fine-tune your stress assumptions to better represent the true risk of the bank’s portfolio.

Of course, for those of you thinking about life of loan losses (CECL) versus incurred losses, the table above may require a slight modification. In the incurred loss method, the stress test should be calibrated to reflect the appropriate loss emergence period because the estimate should represent “probable but unknown” losses, while in CECL it should consider the remaining life of the loan because the estimate should represent “expected” losses. This can lead you to different results and should be handled with care in any attempt to augment the ALLL (or ACL) with stress testing. However, the concept remains the same in both models.

By assigning a likelihood of the convergence of today’s economy with the stress test’s economy, you can create a logical framework for adjusting the ALLL. Of course, this requires a robust stress testing process that uses the proper techniques. Your stress test also needs to have the capability to be quickly modified as you learn more about COVID-19’s impact on the economy. Breaking out different industry groups, property types, etc. will help the stress test become more applicable for your ALLL. And finally, performing the stress test analysis quarterly (or even more frequently) is the best way to capture the impact of this rapidly shifting economic environment on your reserve.