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Factors That Move the Needle - Moody's Analytics...Factors That Move the Needle 7 Collective...
Transcript of Factors That Move the Needle - Moody's Analytics...Factors That Move the Needle 7 Collective...
Factors That Move the Needle 2
1. Foundational Elements
2. Economic Scenarios and Loss Forecasting
3. Conclusion
Agenda
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
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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
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Q1
20
12
Q4
20
13
Q3
20
14
Q2
20
15
Q1
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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
“ ”
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.
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
moodysanalytics.com
Anna Krayn
Masha Muzyka
With thanks to Jin Oh, Ed Young
Factors That Move the Needle 30
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