Given the increased regulatory scrutiny over the allowance for loan and lease losses (ALLL) in the past several years, regulators, auditors and senior management are all looking for additional ways to measure the effectiveness of the bank or credit union’s ALLL methodology. The OCC’s 2011 Supervisory Guidance on Model Risk Management specifically states, “Model risk should be managed like other types of risk,” highlighting the criticality of some form of outcome analysis.
The objective is to ensure the ALLL methodology is accurate in measuring the losses inherent in a bank’s portfolio over the subsequent 12-month period. This time horizon may shift somewhat as the FASB’s CECL proposal and the life of loan concept takes hold, but regardless of any forthcoming changes, the request for measuring the effectiveness of a methodology, or backtesting ALLL models, will continue in some fashion.
Backtesting is an exercise that compares the actual outcome with model forecasts during a defined period, a period of time that was not used to develop the methodology. A good starting point for any measure of efficacy is backtesting a reserve methodology on the portfolio.
To learn more about backtesting, view our webinar on Backtesting your ALLL methodology.