Factors That Move the Needle - Moody's Analytics...Factors That Move the Needle 7 Collective...

30
Expected Loss Quantification: Factors That Move the Needle September 2017

Transcript of Factors That Move the Needle - Moody's Analytics...Factors That Move the Needle 7 Collective...

Expected Loss Quantification:

Factors That Move the Needle

September 2017

Factors That Move the Needle 2

1. Foundational Elements

2. Economic Scenarios and Loss Forecasting

3. Conclusion

Agenda

1 Foundational Elements

Factors That Move the Needle 4

From the Interagency Guidance…

…better alignment of allowance estimation

practices with existing credit risk assessment and

risk management practices is likely, as the new

accounting standard allows a financial institution

to leverage its current internal credit risk systems

as a framework for estimating expected credit

losses.

Interagency Frequently Asked Questions on the New Accounting

Standard on Financial Instruments – Credit Losses

“ ”

Factors That Move the Needle 5

Starting Points for CECL ImplementationDo you anticipate leveraging existing models in your CECL process?

0%

5%

10%

15%

20%

25%

30%

35%

40%

No, I don't expect toleverage any existing

models for CECL

Yes, credit riskmanagement loss

forecasting models

Yes, credit riskmanagement scorecards/ models (e.g., Dual Risk

Rating models)

Yes, incurred loss ALLLmethodology

Yes, stress testing(DFAST) methodology

29%

14%14%

36%

Moody’s Analytics, February 2017

7%

Factors That Move the Needle 6

Common Pitfalls: Segmentation MattersExample: Call Report Level NCOs

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

19

91

Q1

19

91

Q4

19

92

Q3

19

93

Q2

19

94

Q1

19

94

Q4

19

95

Q3

19

96

Q2

19

97

Q1

19

97

Q4

19

98

Q3

19

99

Q2

20

00

Q1

20

00

Q4

20

01

Q3

20

02

Q2

20

03

Q1

20

03

Q4

20

04

Q3

20

05

Q2

20

06

Q1

20

06

Q4

20

07

Q3

20

08

Q2

20

09

Q1

20

09

Q4

20

10

Q3

20

11

Q2

20

12

Q1

20

12

Q4

20

13

Q3

20

14

Q2

20

15

Q1

20

15

Q4

20

16

Q3

Net Charge Off Rate for C&I and CRE Loans 1991 - 2016

C&I CRE

NC

O %

Was the performance of all

CRE property types and

markets affected the same

during the Great Recession?

NCO %, NSAAR for all Commercial Banks; Source: FRB via Moody’s Analytics Data Buffet

Were loans to all firms in the

C&I sector adversely affected

by the “Dotcom Crash” in

2001?

What about today’s

credit conditions?

…or the near-term

future?

… or your individual

portfolio concentrations?

Factors That Move the Needle 7

Collective (“Pool”) Evaluation

» Required for financial assets when similar risk

characteristic(s) exists

Individual Evaluation

» Required when a financial asset does not share

risk characteristics with its other financial assets

» Internal or external credit score

» Risk ratings or classification

» Financial asset type

» Collateral type

» Size

Examples of Shared Risk Characteristics

» Effective interest rate

» Term

» Geographical location

» Industry of the borrower

» Vintage

CECL Requirement: “Pool” Evaluation of ECL

When Similar Risk Characteristics Exist

Factors That Move the Needle 8

0% 10% 20% 30%

RR 1

RR 2

RR 3

RR 4

RR 5

RR 6

RR 7

RR 8

% of Commercial Loans

A Word on Risk Ratings ProcessesR

isk

Rati

ng

Ca

teg

ori

es

Performing Loans

Non-Performing Loans

» Pool-based reserve

» Loss rate by rating

category or based on

peer group

» PD/LGD based

approach

» Loan specific reserve

» Discount cash flows

COMMON STORY

» Expert judgment driven assessment of risk

» Risk rating represents rank ordering of expected loss

» No separation between borrower risk and facility risk

BETTER WAY

0% 5% 10% 15%

BRR 1

BRR 2

BRR 3

BRR 4

BRR 5

BRR 6

BRR 7

BRR 8

BRR 9

BRR 10

BRR 11

BRR 12

BRR 13

BRR 14

BRR 15

% of Commercial Loans

Ris

k R

ati

ng

Ca

teg

ori

es

Performing Loans

Non-Performing Loans

» Dual risk ratings: borrower (BRR) distinct from facility

» Often associated with Advanced Basel II/III approaches

for capital calculation

» Risk drivers include qualitative and quantitative

components

Factors That Move the Needle 9

0% 10% 20% 30%

RR 1

RR 2

RR 3

RR 4

RR 5

RR 6

RR 7

RR 8

% of Commercial Loans

» Benefits of a more refined risk rating process:

– Can isolate drivers of credit risk more effectively

– Reduces the subjectivity within the risk-rating process

– Enables a bank to develop more repeatable, reasonable,

and supportable forecasts

Why Are Accurate Risk Ratings are Critical?R

isk

Rati

ng

Ca

teg

ori

es

Performing Loans

Non-Performing Loans

» Pool-based reserve

» Loss rate by rating

category or based on

peer group

» PD/LGD based

approach

» Loan specific reserve

» Discount cash flows

COMMON STORY

» Could lead to clustering of credits in certain pass risk

grades.

» Questions:

– Meaning of ratings?

– Master rating scale concentrations?

– Portfolio segmentation?

BETTER WAY

0% 5% 10% 15%

BRR 1

BRR 2

BRR 3

BRR 4

BRR 5

BRR 6

BRR 7

BRR 8

BRR 9

BRR 10

BRR 11

BRR 12

BRR 13

BRR 14

BRR 15

% of Commercial Loans

Ris

k R

ati

ng

Ca

teg

ori

es

Performing Loans

Non-Performing Loans

Factors That Move the Needle 10

From Risk Rating to CECL

Risk Ratings

Unfavorable

Favorable

Qualitative Adjustment

ACL (Med-High)

ACL (High)

ACL (Very High)

ACL (Medium)

ACL (Med-Low)

ACL (Low)

ACL (Very Low)

Deteriorating

Improving

Economic Forecast

Deteriorating

Improving

Current Conditions

RISK

RATING

Life of the Instrument

Increase in loss allowance under

CECL to be driven by:

» Level of PDs and LGDs

» State of the business cycle

» Reasonable and supportable

forecasts

» Maturity of exposures

Note that most risk ratings systems are designed to be through-the-cycle, i.e. not overly sensitive to current conditions

Leve

l of A

llow

ance

Factors That Move the Needle 11

What if CECL Was In Effect in 2007?

Case Study» Sample of 200 C&I loans (non-financial institutions)

» 2007 Q1 originations, >3-year maturities

» Internally rated 1-5 (pass grades as of Q4 2007)

» Analysis periods from 2007 Q4 to 2009 Q4

» Moody’s economic forecast scenarios as of 2007Q4,

2008 Q4 and 2009 Q4

Question: Does granularity matter?

AssumptionsFor the Rating-based Analysis:

» PD measures were derived from internal ratings (1-5)

that were mapped to the Moody’s rating-based PD map

For the PD-based Analysis:

» PD measures were calculated based on the obligor’s

financial statement and economic cycle adjustments,

independently of the internal ratings

Factors That Move the Needle 12

Does Granularity Matter? Yes!

Granular analysis using objective

quantitative tools as part of the

process provide for a more

accurate view of credit risk.

Factors That Move the Needle 13

Differences Are More Pronounced At Instrument Level

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

PD to maturity based on internal rating PD to maturity based on PIT PD % ECL to maturity based on internal rating % ECL to maturity based on PIT PD

Instruments that are internally rated 5 with the TTC (long term) rating-implied PD of 1.51%:

1 2 3 4 5 6 7

PD to maturity based on internal rating 1.52% 1.52% 1.51% 1.50% 1.49% 1.48% 1.43%

PD to maturity based on PIT PD 2.54% 3.14% 2.87% 2.54% 3.88% 2.48% 3.13%

% ECL to maturity based on internal rating 2.43% 2.22% 1.68% 1.61% 1.15% 1.13% 0.61%

% ECL to maturity based on PIT PD 4.01% 2.36% 2.14% 2.79% 1.61% 3.70% 3.37%

MedianMin-to-Max Range

Individual Instruments

Factors That Move the Needle 14

CECL as Pricing and Capital Advantage

[Bankers] will likely be expected to integrate the assumptions used

in their CECL loss estimates (mainly those pertaining to forecasts

of the future) with those used in asset/liability management, capital

management, and overall budgeting. CECL’s requirement to

record a life of loan loss estimate at origination (in other words,

recognize the cost up front), for practical purposes, will force a

bank to weigh the potential risks much more closely before

expanding its business. This can change bank behavior.

FASB’s Current Expected Credit Loss Model for Credit Loss Accounting (CECL):

Background and FAQ’s for Bankers

American Bankers Association, June 2016

“ ”

2 Economic Scenarios and

Loss Forecasting

Factors That Move the Needle 16

The Trouble With Our Predictions

It’s hard enough to know where the

economy is going. But it’s much, much

harder if you don’t know where it is to

begin with.

Nate Silver

“The Signal and The Noise”

“ ”

Factors That Move the Needle 17

Realized Recession Was Worse but Recovered Fast

The Fed’s SCAP forecast from Early 2009

Factors That Move the Needle 18

Finding Right Economic Variables for Risk Attributes is Critical

4%

5%

6%

7%

8%

9%

10%

11%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

1.6%

US

Un

emp

loym

ent

Rat

e

Loss

Rat

e

Lifetime Loss Rates vs. Unemployment Rate

Lifetime Loss Rate US Unemployment Rate

4%

5%

6%

7%

8%

9%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

1.6%

US

Baa

Yie

ld

Loss

Rat

e

Lifetime Loss Rate vs. Credit Spreads

Lifetime Loss Rate US Baa Yield

Factors That Move the Needle 19

What is Reasonable and Supportable?

CECL Model» Is the length of observed historical performance

sufficient to project losses?

» Is observed history of performance relevant for the

future time horizon?

» Is the methodology used reasonable and supportable

over the time horizon?

Two Considerations to Determine Forecast Horizon:

Forecast» Are forecasts for forward-looking drivers

econometrically determined?

» Is data with limited history being extrapolated?

» Are economic cycles being forecasted in a reasonable

fashion?

Factors That Move the Needle 20

Range of Moody’s Analytics Macroeconomic Scenarios

Stronger Near-Term Growth

Slower Near-Term Growth

Moderate Recession

Protracted Slump

Below-Trend Long-Term Growth

Stagflation

Next-Cycle Recession

Low Oil Price

Consensus Scenario

Baseline Scenario

S1

S2

S3

S4

S5

S6

S7

S8

CF

Economic scenarios (2017)

BLBL

Housing Market Recovery, Mild Recession

Housing Market Crash, Severe Recession

BL

S2

S4

Economic scenarios (2007)

Baseline Scenario

Real GDP growth rate, % Yr/Yr

Factors That Move the Needle 21

Range of Scenarios in 2007 Compared to Actual

(Right Axis - Levels)

(Right Axis - levels)

(Right Axis - Levels)

(Right Axis - Levels)(Left Axis - %)

(Left Axis - %)

(Left Axis - %)

(Left Axis - %)

Factors That Move the Needle 22

What if CECL Was In Effect in 2007? (Continued)

Questions to Test» What can we learn about impact of reasonable &

supportable period length?

– Revert to Moody's long term PDs

– Compare 1 year, 2 year and no mean reversion

» Is there benefit to using more than one scenarios?

– Compare outcomes based on different

scenarios

– Compare probability-weighted outcome of 3

scenarios to a single scenario

AssumptionsEconomic variables for C&I portfolio

» US Unemployment Rate

» S&P Equity Index

» CBOE Volatility Index (VIX)

» Intermediate Term BBB Bond Spread

Factors That Move the Needle 23

Testing Impact of Scenario Selection

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

1 Year reversion 2 Year reversion No reversion

Baseline

Baseline Scenario

2007Q4 PD ECL 2008Q4 PD ECL 2009Q4 PD ECL

% E

CL

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

1 Year reversion 2 Year reversion No reversion

70:15:15

Scenario Combination (70% BL: 15% S2: 15% S4)

2007Q4 PD ECL 2008Q4 PD ECL 2009Q4 PD ECL

% E

CL

Reversion to historical information beyond reasonable horizon addresses

forecast uncertainty…. As does forecasting under multiple scenarios.

3 Conclusion

Factors That Move the Needle 25

Standard DeviationIncurred

LossCECL

2003Q3 – 2015Q4 0.55% 0.83%

Crisis Period

(2007Q1 – 2010Q4)0.66% 1.04%

0%

1%

2%

3%

4%

5%

2003Q3 2005Q3 2007Q3 2009Q3 2011Q3 2013Q3 2015Q3

Modeled C&I Allowance Rate, Incurred Loss

Next 4-Quarter NCO Rate (FR Y-9C)

Modeled C&I Allowance Rate, CECL

What If CECL Was in Place During Financial Crisis…Bank Level View

From What Do Half a Million Loans Say About the Impact of CECL on Loan Loss Allowance?

by Dr. Yanping Pan, Dr. Yashan Wang, July 2017

Factors That Move the Needle 26

Looking ahead…The opportunity to align risk management processes and forecasts

Stress

Testing

Risk

Management

CECL

Integrated

Process

Today Target State Benefits

» Build toward risk-based pricing

» Cost of model ownership and

maintenance

» Common language of risk between

use cases

» More nimble risk strategy and

active quantitative portfolio

management

A About Moody’s Analytics

Factors That Move the Needle 28

Moody’s Analytics Core Capabilities

moodysanalytics.com

Anna Krayn

[email protected]

Masha Muzyka

[email protected]

With thanks to Jin Oh, Ed Young

Factors That Move the Needle 30

© 2017 Moody’s Corporation, Moody’s Investors Service, Inc., Moody’s Analytics, Inc. and/or their licensors and affiliates (collectively, “MOODY’S”). All

rights reserved.

CREDIT RATINGS ISSUED BY MOODY'S INVESTORS SERVICE, INC. AND ITS RATINGS AFFILIATES (“MIS”) ARE MOODY’S CURRENT

OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES, AND

MOODY’S PUBLICATIONS MAY INCLUDE MOODY’S CURRENT OPINIONS OF THE RELATIVE FUTURE CREDIT RISK OF ENTITIES, CREDIT

COMMITMENTS, OR DEBT OR DEBT-LIKE SECURITIES. MOODY’S DEFINES CREDIT RISK AS THE RISK THAT AN ENTITY MAY NOT MEET

ITS CONTRACTUAL, FINANCIAL OBLIGATIONS AS THEY COME DUE AND ANY ESTIMATED FINANCIAL LOSS IN THE EVENT OF DEFAULT.

CREDIT RATINGS DO NOT ADDRESS ANY OTHER RISK, INCLUDING BUT NOT LIMITED TO: LIQUIDITY RISK, MARKET VALUE RISK, OR

PRICE VOLATILITY. CREDIT RATINGS AND MOODY’S OPINIONS INCLUDED IN MOODY’S PUBLICATIONS ARE NOT STATEMENTS OF

CURRENT OR HISTORICAL FACT. MOODY’S PUBLICATIONS MAY ALSO INCLUDE QUANTITATIVE MODEL-BASED ESTIMATES OF CREDIT

RISK AND RELATED OPINIONS OR COMMENTARY PUBLISHED BY MOODY’S ANALYTICS, INC. CREDIT RATINGS AND MOODY’S

PUBLICATIONS DO NOT CONSTITUTE OR PROVIDE INVESTMENT OR FINANCIAL ADVICE, AND CREDIT RATINGS AND MOODY’S

PUBLICATIONS ARE NOT AND DO NOT PROVIDE RECOMMENDATIONS TO PURCHASE, SELL, OR HOLD PARTICULAR SECURITIES.

NEITHER CREDIT RATINGS NOR MOODY’S PUBLICATIONS COMMENT ON THE SUITABILITY OF AN INVESTMENT FOR ANY PARTICULAR

INVESTOR. MOODY’S ISSUES ITS CREDIT RATINGS AND PUBLISHES MOODY’S PUBLICATIONS WITH THE EXPECTATION AND

UNDERSTANDING THAT EACH INVESTOR WILL, WITH DUE CARE, MAKE ITS OWN STUDY AND EVALUATION OF EACH SECURITY THAT IS

UNDER CONSIDERATION FOR PURCHASE, HOLDING, OR SALE.

MOODY’S CREDIT RATINGS AND MOODY’S PUBLICATIONS ARE NOT INTENDED FOR USE BY RETAIL INVESTORS AND IT WOULD BE

RECKLESS AND INAPPROPRIATE FOR RETAIL INVESTORS TO USE MOODY’S CREDIT RATINGS OR MOODY’S PUBLICATIONS WHEN

MAKING AN

INVESTMENT DECISION. IF IN DOUBT YOU SHOULD CONTACT YOUR FINANCIAL OR OTHER PROFESSIONAL ADVISER.

ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY LAW, INCLUDING BUT NOT LIMITED TO, COPYRIGHT LAW, AND NONE OF

SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED,

DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART,

IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT.

All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of human

or mechanical error as well as other factors, however, all information contained herein is provided “AS IS” without warranty of any kind. MOODY'S

adopts all necessary measures so that the information it uses in assigning a credit rating is of sufficient quality and from sources MOODY'S considers

to be reliable including, when appropriate, independent third-party sources. However, MOODY’S is not an auditor and cannot in every instance

independently verify or validate information received in the rating process or in preparing the Moody’s publications.

To the extent permitted by law, MOODY’S and its directors, officers, employees, agents, representatives, licensors and suppliers disclaim liability to

any person or entity for any indirect, special, consequential, or incidental losses or damages whatsoever arising from or in connection with the

information contained herein or the use of or inability to use any such information, even if MOODY’S or any of its directors, officers, employees, agents,

representatives, licensors or suppliers is advised in advance of the possibility of such losses or damages, including but not limited to: (a) any loss of

present or prospective profits or (b) any loss or damage arising where the relevant financial instrument is not the subject of a particular credit rating

assigned by MOODY’S.

To the extent permitted by law, MOODY’S and its directors, officers, employees, agents, representatives, licensors and suppliers disclaim liability for

any direct or compensatory losses or damages caused to any person or entity, including but not limited to by any negligence (but excluding fraud,

willful misconduct or any other type of liability that, for the avoidance of doubt, by law cannot be excluded) on the part of, or any contingency within or

beyond the control of, MOODY’S or any of its directors, officers, employees, agents, representatives, licensors or suppliers, arising from or in

connection with the information contained herein or the use of or inability to use any such information.

NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR

ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY

FORM OR MANNER WHATSOEVER.

Moody’s Investors Service, Inc., a wholly-owned credit rating agency subsidiary of Moody’s Corporation (“MCO”), hereby discloses that most issuers of

debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by Moody’s Investors

Service, Inc. have, prior to assignment of any rating, agreed to pay to Moody’s Investors Service, Inc. for appraisal and rating services rendered by it

fees ranging from $1,500 to approximately $2,500,000. MCO and MIS also maintain policies and procedures to address the independence of MIS’s

ratings and rating processes. Information regarding certain affiliations that may exist between directors of MCO and rated entities, and between entities

who hold ratings from MIS and have also publicly reported to the SEC an ownership interest in MCO of more than 5%, is posted annually at

www.moodys.com under the heading “Investor Relations — Corporate Governance — Director and Shareholder Affiliation Policy.”

Additional terms for Australia only: Any publication into Australia of this document is pursuant to the Australian Financial Services License of

MOODY’S affiliate, Moody’s Investors Service Pty Limited ABN 61 003 399 657AFSL 336969 and/or Moody’s Analytics Australia Pty Ltd ABN 94 105

136 972 AFSL 383569 (as applicable). This document is intended to be provided only to “wholesale clients” within the meaning of section 761G of the

Corporations Act 2001. By continuing to access this document from within Australia, you represent to MOODY’S that you are, or are accessing the

document as a representative of, a “wholesale client” and that neither you nor the entity you represent will directly or indirectly disseminate this

document or its contents to “retail clients” within the meaning of section 761G of the Corporations Act 2001. MOODY’S credit rating is an opinion as to

the creditworthiness of a debt obligation of the issuer, not on the equity securities of the issuer or any form of security that is available to retail

investors. It would be reckless and inappropriate for retail investors to use MOODY’S credit ratings or publications when making an investment

decision. If in doubt you should contact your financial or other professional adviser.

Additional terms for Japan only: Moody's Japan K.K. (“MJKK”) is a wholly-owned credit rating agency subsidiary of Moody's Group Japan G.K., which

is wholly-owned by Moody’s Overseas Holdings Inc., a wholly-owned subsidiary of MCO. Moody’s SF Japan K.K. (“MSFJ”) is a wholly-owned credit

rating agency subsidiary of MJKK. MSFJ is not a Nationally Recognized Statistical Rating Organization (“NRSRO”). Therefore, credit ratings assigned

by MSFJ are Non-NRSRO Credit Ratings. Non-NRSRO Credit Ratings are assigned by an entity that is not a NRSRO and, consequently, the rated

obligation will not qualify for certain types of treatment under U.S. laws. MJKK and MSFJ are credit rating agencies registered with the

Japan Financial Services Agency and their registration numbers are FSA Commissioner (Ratings) No. 2

and 3 respectively.

MJKK or MSFJ (as applicable) hereby disclose that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and

commercial paper) and preferred stock rated by MJKK or MSFJ (as applicable) have, prior to assignment of any rating, agreed to pay to MJKK or

MSFJ (as applicable) for appraisal and rating services rendered by it fees ranging from JPY200,000 to approximately JPY350,000,000.

MJKK and MSFJ also maintain policies and procedures to address Japanese regulatory requirements.