The benefits of segmentation within the Allowance for Loan and Lease Loss calculation are many. Institutions can gain more insight into sub-segmented performance, conduct more sophisticated loss methodologies such as migration analysis and can make better-informed lending decisions over time. However, as the old adage goes, there certainly can be “too much of a good thing,” and a tipping point exists in which institutions run the risk of over-segmentation.
As stated in the Comptroller’s Handbook, “Effective management of the loan portfolio and the credit function is fundamental to a bank’s safety and soundness.” The ability to adequately meet ALLL, stress testing and other risk management requirements relies upon sound segmentation practices.
The Comptroller’s Handbook also states that an institution must understand “the portfolio’s product mix, industry and geographic concentrations, average risk ratings and other aggregate characteristics.” In other words, management must have a way to accurately assess risk on both a portfolio level and within the various components of their portfolio in order to both be in compliance and to steer portfolio objectives, risk tolerances and strategic planning.
Thus the question presents itself – “How much should an institution segment its FAS 5 (ASC 450-20) pools?” As is the case with many interpretations of guidance, the answer to this quandary is “it depends.”
The extent of segmentation depends largely on portfolio size. The key to implementing successful segmentation processes is to be as granular as possible without losing statistical significance. You want a segmentation process that is granular enough to show pools of loans with similar characteristics, but you want to be sure the balances of the pools do not become so small that the impact of changing one variable overwhelmingly changes the outlook for the pool as a whole.
There is certainly room for improvement in many institutions’ segmentation practices. Prior to the Great Recession, the ALLL received little scrutiny, and the tendency was for financial institutions to use broad segmentation criteria. Still today, many institutions use Consumer, Real Estate, Commercial, etc. to segment their portfolios. Chuck Nwokocha, senior risk management consultant at Sageworks, believes that generality within segmentation is inadeqaute and recommends institutions use at least two levels of sub-segmentation.
Take for instance Commercial Real Estate (CRE). An institution could break out owner versus non-owner occupied; then assign a measurement attribute such as risk rating or risk grade. This methodology will not only grant institutions further insight into their portfolios, but it also gives them the capacity to graduate to migration analysis, which is largely viewed as a more robust form of analysis by examiners.
In conclusion, there is no “one size fits all” approach to segmenting an institution’s portfolio. However, many industry professionals believe that granular segmentation practices are largely underdeveloped in today’s banking landscape. Institutions that wish to bolster their ALLL and gain more insight into portfolio performance should examine their current segmentation practices and determine if there is room for improvement.
To explore more on segmentation, access our complimentary whitepaper, Benefits of Segmentation in the ALLL and Beyond.