The environmental and economic factor is often an important piece to the allowance for loan loss (ALL calculation) that is often neglected. A common refrain for omitting this factor is not knowing what to include in the analysis. It is an answer that is unique to each financial institution. In order to reasonably determine a necessary environmental and economic factor, it helps to step back and ask one question: What factors will affect my charge-offs going forward that aren’t reflected in my historical data? This question is also the crux of the new CECL model, since too often financial institutions simply looked back at the historical data instead of looking forward to what was coming. However, until 2020, when CECL is effective for all entities, it is a good idea to strengthen the current economic and environmental factors. Some common factors that should be considered include the following:
- Changes in underwriting standards as well as changes to lending policies, procedures and practices
- Experience, ability and depth of lending management and other relevant staff
- Levels of and trends in delinquencies and impaired loans
- National/local economic trends and conditions
- Industry conditions
When reviewing these factors, it is important to note how each compares to your historical data. For example, if local unemployment rates had consistently been around 5 percent during the historical data period, than a current unemployment rate of 5 percent would presumably have no effect on expected future charge-offs. An adjustment to the allowance might not be warranted in this circumstance. However, if the most recent unemployment rate increased to 5.5 percent, it might be likely that increased delinquencies and charge-offs will be seen in the near future. In this scenario, it would be reasonable to expect an increase to the ALL to account for the increase in unemployment rates.
Now that you’ve determined what economic and environmental factors apply to your financial institution, you need to quantify the affect, if any, each factor will have on your charge-offs. When possible, it is best to support your conclusion with data. For example, given the scenario in the previous paragraph, it might be possible to look back at prior years when the unemployment rate was 5.5 percent to see charge-off ratios from that period. Those ratios could then be compared to the current charge-off ratios in order to estimate the increase in charge-off rates the financial institution might expect to see in the near future. Note that it might not be possible to look at previous results; for example, a change in underwriting standards probably has no historical period to look back to. These situations will require a “best guess” assumption that may need to be revisited as actual results start to hit the historical data.
With any analysis or calculation that incorporates assumptions it is important to document the reasoning behind the estimates/assumptions that were used to support your conclusion.
Potential data sources:
- The Wisconsin Department of Workforce Development publishes monthly unemployment estimates which can be found at: https://dwd.wisconsin.gov/dwd/news.htm
- The Minnesota Department of Employment and Economic Development publishes various reports which can be found at: https://mn.gov/deed/newscenter/publications/
- The Bureau of Labor Statistics provides unemployment detail by state as well as breakdowns for Metropolitan Statistical Areas. Wisconsin detail can be found at: https://www.bls.gov/eag/eag.wi.htm. Minnesota detail can be found at: https://www.bls.gov/eag/eag.mn.htm
- The Federal Reserve System publishes the Beige Book eight times a year that provides information for the national economy as well as each individual Federal Reserve district. The reports can be found at: https://www.federalreserve.gov/monetarypolicy/beige-book-default.htm