How Well Do You Know Your Loan Portfolio?
With a deeper understanding of their loan portfolios, financial institutions can minimize CECL’s impact on their income statement
CECL implementation will require financial institutions to book loan loss allowances for the life of the loan at the time of origination, and if that changes over time a financial institution’s income can suffer.
Starting in 2020, the new CECL accounting standard will impact how the risk of loss is calculated on a forward-predictive basis, and—with a better understanding of their portfolio’s performance—financial institutions can accurately calculate their loss allowance to optimize portfolio profitability and reduce income volatility.
To accomplish this, banks and credit unions must first understand which loans are driving profitability versus which ones are hindering profitability as well as how loans are being decisioned and how they are being priced.
In other words, how well does your institution know its loan portfolio?
Examining the Origination Process
Gaining a better understanding of your loan portfolio starts by examining the loan origination process.
The intent of the new CECL accounting standard is to encourage financial institutions to recognize how exposure to risk impacts the performance of a loan portfolio over its lifetime, which requires an accurate view of the loan at the time it is originated.
To start, institutions should strive to analyze credit requests as efficiently and consistently as possible based on their unique credit policies. Optimizing the consistency and efficiency of originations will result in your institution having an accurate view of how changes in risk exposure will influence a loan’s performance. Also, this will ensure that an anomaly like an inconsistently priced loan doesn’t impact your entire portfolio’s performance and its loss allowance.
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Guaranteeing that underwriters have a complete view of loan applicants through access to relevant data is crucial as well.
With a comprehensive, data-driven view of a loan applicant, your financial institution can confidently know how loans are being decisioned and priced. This facilitates a deeper understanding of which loans are profitable and which ones are costing your institution money, as well as when there is a change in credit quality.
From there, it is much easier to drill down and identify what factors influence the loan’s performance.
Organize, Segment, and Repeat
To accurately identify what impacts a portfolio’s performance, loans must be organized according to the type of loan product, whether it is an auto loan or a credit card, as well as the term of the loan.
Then, loans should be segmented even further into pools, where loans that perform similarly through various economic cycles are grouped together.
For example, a portfolio of auto loans with a five-year term could be segmented into several groups, which may include a group that consistently performed well through an economic downturn or a group that was negatively impacted by the recession.
By effectively segmenting and pooling loan portfolios, banks and credit unions gain valuable insight on the performance of each loan pool, which also supports better monitoring for changes in credit quality.
In addition to segmenting the portfolio, regularly collecting credit quality indicators for each loan (like FICO scores or debt service coverage) will improve your financial institution’s ability to identify portfolio trends and determine which economic factors that each portfolio is sensitive to.
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In other words, cross-analyzing changes in credit quality with external data like unemployment rates or housing values helps financial institutions distinguish what causes those changes in credit quality.
With an improved understanding of why loan portfolios perform the way they do as a result of CECL implementation, banks and credit unions can effectively correlate how risk can affect their institution’s earnings.
In the future, this knowledge can drive other process improvements for financial institutions, including how they approach underwriting, loan pricing, and marketing offers.
Posted on Friday, August 24, 2018 at 2:00 PM
by Baker Hill