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ALLL and the New Estimate of Loan Losses An update on the proposed impairment model and improving the measurement of credit losses MICH ARATEN, MANAGING DIRECTOR, CREDIT RISK CAPITAL ADVISORY OCTOBER 2013 CHRIS HENKEL, DIRECTOR, MOODYS

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ALLL and the New Estimate of Loan Losses

An update on the proposed impairment model and improving the measurement of credit losses

OCTOBER 2013 MICH ARATEN, MANAGING DIRECTOR, CREDIT RISK CAPITAL ADVISORY CHRIS HENKEL, DIRECTOR, MOODY’S ANALYTICS

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2 FASB Impairment Standards and ALLL, October 2013

0% 5% 10% 15% 20% 25% 30% 35% 40%

Loan Loss Provision as % of Net Operating Revenue

(all FDIC-Insured Institutions)

Provisioning for loan losses consumes a significant portion of the banking industry‟s net operating revenue

Source: FDIC

5.04% 2Q13 37.94% 5.18%

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3 FASB Impairment Standards and ALLL, October 2013

Despite the rapid provisioning during the crisis, the ratio

f reserves to noncurrent loans continued to fall

0% 20% 40% 60% 80% 100% 120% 140% 160% 180% 200% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50% 4.00% Reserves/TL Reserves/NCL

Source: FDIC

3.51% 0.64%

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4 FASB Impairment Standards and ALLL, October 2013

Agenda

1. Brief Review of Existing Guidance
2. Overview of FASB‟s Proposed Current Expected Credit Loss Model
3. Analytical Considerations and Loan Loss Reserves
4. Stress Testing and Reserves

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5 FASB Impairment Standards and ALLL, October 2013

Brief Review of Existing Guidance

1

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6 FASB Impairment Standards and ALLL, October 2013

An appropriate ALLL, in accordance with GAAP, should reflect an estimate of probable credit losses

Estimated credit losses means an estimate of the current amount of loans that is probable the institution will be unable to collect given facts and circumstances as of the evaluation date. Thus, estimate credit losses represent charge-offs that are likely to be realized for a loan or group of loans.

Interagency guidance, 2006

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7 FASB Impairment Standards and ALLL, October 2013

The principal sources of guidance on GAAP accounting for credit losses are FAS 5 and FAS 114

Measurement of Estimated Credit Losses Loan Portfolio

Impaired?

No Yes

FAS 5 FAS 114

PV of FCF Mkt. Price FV of Coll. Segmented Risk Pools

Unallocated

Portion of the ALLL that is not attributed to specific segments of the loan portfolio

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8 FASB Impairment Standards and ALLL, October 2013 8

» Accrue an amount that appears to be a better estimate than others within a range of estimates » Accrual vs. Disclosure

If it is “probable” that a loss will incur and the amount can be reasonably

estimated, it should be accrued in the financial statements

If it is “reasonably possible” that a loss will incur, it should be disclosed in

the notes without recognition in the financial statements

If the possibility of loss is “remote”, disclosure is not required

ASC 450-20

Loss Contingencies

ASC 310-10

Receivables

In 2009, FASB codified the accounting standards for recognition of credit losses

» A loan is impaired when it is probable that all amounts due from a loan are impaired » To determine whether a loan is impaired, the institution should apply its normal loan/credit review process » Impairment loss = Carrying amount of the loan, less:

Fair value of the collateral (collateral dependent loans); or
PV of expected future cash flows from a loan; or
Observable market price of the loan

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9 FASB Impairment Standards and ALLL, October 2013

The incurred loss approach is believed to interfere with the timely recognition of credit losses

» It prevents banks from provisioning for an impaired asset until a “triggering event” occurs » Banks must wait until the triggering event has already occurred before they recognize the loss » By waiting, the model precludes banks from provisioning for risks the bank can reasonably anticipate to occur » It leads to pro-cyclicality and delayed loss recognition » Changes in the probabilities of loss and of loss exposures should be reflected in the ALLL » The OCC supports FASB‟s proposed expected loss model over the current incurred loss impairment approach

Concerns Over the Current Incurred Loss Model

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10 FASB Impairment Standards and ALLL, October 2013

Overview of FASB’s proposed Current Expected Credit Loss Model (CECL)

2

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11 FASB Impairment Standards and ALLL, October 2013

Evolution of a new impairment model

Over the last five years, the accounting community has worked to provide more actionable information about the expected credit losses on financial assets

May 2013 Comment period ended

Evolution of Subtopic 825-15, Financial Instruments – Credit Losses

(superseding ASC 310-10 (SFAS 114) and 450-20 (SFAS 5) - among others)

October 2008 Joint effort b/w FASB and IASB to address reporting issues arising from the global financial crisis July 2009 Financial Crisis Advisory Group (FCAG) published report on delayed recognition of losses and complexity with different impairment approaches. Included forward-looking information. November 2009 IASB published Exposure Draft, adding further support for a forward-looking measure

f ECL

May 2010 FASB published a proposed ASU to ECL »Remaining life »Cash flow based »Economic conditions remain unchanged January 2011 FASB and IASB published a supplementary document introducing “Good Book” and “Bad Book” distinction July 2012 FASB and IASB jointly released the “three- bucket” impairment model whereby credit instruments would have had different measurement approaches and migration criteria across buckets December 2012* FASB published the Exposure Draft “Proposed Accounting Standards Update, Financial Instruments – Credit Losses.” Introduced the CECL. *Current proposal; IASB had not concluded deliberation on credit losses at the time of release

Source: FASB

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12 FASB Impairment Standards and ALLL, October 2013

The proposed accounting standards update reflects several core objectives

Objectives of the proposed update

» More timely recognition of credit losses » Greater transparency regarding the expected credit losses » Improved understanding of the realizability

f assets and the inherent credit risk in the

portfolio » Improved understanding of credit risk changes that have taken place during the period » Improved understanding of purchased credit-impaired financial assets » Improved understanding and comparability

f interest income

» Enhanced consistency when credit impairment is measured at the individual asset level as compared with at the portfolio level

Source: FASB

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13 FASB Impairment Standards and ALLL, October 2013

Working towards these standards will require a blend of judgment and empirical evidence

» The allowance for credit losses (ACL) should be management‟s best estimate of the PV of all contractual cash flows that are not expected to be collected on an asset or group of like assets as of the financial statement date

– The timing and amount of the CFs is not required under the new proposal

Management Judgment Empirical Evidence

» The ECL should take into account:

– Historical loss experience (NCOs) with similar assets – need to appropriately segment – Current conditions – prevailing credit cycle and business environment (including macroeconomic factors, collateral values, borrower behavior, underwriting standards, etc.) – Reasonable and supportable forecasts (**New**) – Time value of money, either explicitly or implicitly

Source: FASB

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14 FASB Impairment Standards and ALLL, October 2013

The approach to estimating credit loss is not “one-size- fits-all,” but there are minimum requirements

» Specific approaches are not mandated but should be consistent and appropriate for the portfolio it is applied to » Minimum requirements (for historical statistics):

– Consistent definition of default – Definition of loss (i.e., amount charged off) – Method for weighting historical experience (i.e., volume- weighted or equal-weighted) – Method for adjusting loss statistics for recoveries – How expected prepayments affect the allowance for ECL – Incorporating the time value of money

» Default probabilities and loss severities are not linear, therefore it is inappropriate to “gross up” a one-year measure over the remaining term

Source: FASB

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15 FASB Impairment Standards and ALLL, October 2013

Example of non-linearity of default probabilities using cumulative measures

A cumulative EDF credit measure gives the probability of default over that time period. For example, a five year cumulative EDF credit measure of 9.64% means that that company has a 9.64% chance of defaulting over that five year period (perhaps the remaining life of the loan). Firm A Firm B

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16 FASB Impairment Standards and ALLL, October 2013

A common measurement approach includes the use of PD, LGD, and EAD along with credit adjustments

Performing Rated Loans ($)

(“Pass”)

Impaired Loans ($) (Pooled basis) Impaired Loans ($) (Individual) Special Reserves ($) (Mgmt Judgment)

PD LGD

Credit Risk Adjustment

RESERVES FOR PERFORMING LOANS

EL Factor

RESERVES FOR IMPAIRED LOANS

Uncollected Cash Flows

RESERVES FOR IMPAIRED LOANS ADDITIONAL RESERVES

TOTAL RESERVES

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EL = PD x LGD x EAD*

… how likely the borrower is to go into default … the estimate of loss (1-recovery) should default occur … the exposure amount at the time

f default

Probability of Default Loss Given Default Exposure at Default

= x x

3% 30¢

n the dollar

$5MM

f the $10MM
riginally lent

likelihood

On average, the amount a lender could potentially lose depends on three things … Expected Loss

$45M

Institutions will need to estimate expected loss over the life of the loan, and also account for current conditions

*For ALLL purposes, the EAD is typically the outstanding loan amount as of the financial reporting date. A different but related reserve is held for unfunded commitments

» These estimates will need to be further adjusted for current economic conditions and the forecasted direction of the economy » In addition to time horizon, another dimension for consideration is the PD measurement (i.e., “Point-in-Time” (PIT) or “Through-the-Cycle” (TTC))

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18 FASB Impairment Standards and ALLL, October 2013

Moreover, risk measures can be expressed in terms of “Point-in-Time” or “Through-the-Cycle”

Source: Moody’s CreditEdge 0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00%

Median EDF for “B” rated companies

Feb. „09: 9.92%
Aug. „13: 0.31%

Median: 1.35%

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19 FASB Impairment Standards and ALLL, October 2013

Recent Developments

Decisions reached to date during deliberations of CECL (through Sept. 27, 2013)

Clarifications Regarding an Entity‟s Estimate of Expected Loss

» Revert to historical average loss experience for future periods beyond supportable forecasts » Consider prepayments but not extensions, renewals, and modifications (other than TDR) » Recognize risk of loss, even if remote, unless amount of loss would be zero » Can use loss-rate models, PD methods, or a provision matrix in addition to DCF models » Final guidance (TBA) will include guidance

n “reasonable and supportable

forecasts”

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20 FASB Impairment Standards and ALLL, October 2013

While CECL brings noted improvements, FASB‟s new impairment model has been met with some dissenters

» The operational impact could be significant » Stakeholders, such as regulators, accountants, investors, and the SEC, do not always share a common interest » Introduces a “life-of-loan” concept which is said to conflict with the conceptual framework » A forward-looking measure may be very difficult to support the estimates » The impact on current allowance levels

̵ An increase of 30% to 300% to the allowance, in addition to a potential one-time increase ̵ At a time when banks are adding capital in

rder to meet new regulatory requirements

» Favor for an alternative, such as a Banking Impairment Model (BIM) Commonly Expressed Concerns

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21 FASB Impairment Standards and ALLL, October 2013

How does FASB‟s CECL align with the IASB‟s proposed Expected Credit Loss Model?

Divergent Attributes

» The IASB‟s model includes three stages:

1. No significant deterioration (12 months ECL are recognized) 2. Significant deterioration (lifetime ECL are recognized) 3. Objective evidence of impairment (lifetime ECL are recognized)

» The FASB CECL has no distinction for deterioration in credit quality; all measured at lifetime ECL » Timing difference in the recognition of ECL

Remains a joint project between FASB and IASB, as they work together to deliberate on comment letters and potentially align on divergent views

Common Attributes

» Removal of the „incurred loss‟ trigger for recognition » Lifetime ECL are the expected shortfalls in contractual cash flows » An estimate of ECL will reflect the probability that a credit loss might occur » The estimate will be based upon use of the same information » The amount of ECL should be the same for financial instruments that have deteriorated significantly in credit quality

Note: The IASB issued an Exposure Draft, Financial Instruments: Expected Credit Losses, on March 7,

2013. The comment period ended on July 5, 2013

Source: IIFRS and IASB

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Analytical Considerations for Loan Loss Reserves

3

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As previously mentioned, the ALLL consists of three distinct components

» Specific reserve for non performing loans » Expected losses for performing loans » Credit risk adjustment applied to expected losses

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24 FASB Impairment Standards and ALLL, October 2013

The impairment for nonperforming loans is usually on an asset-specific basis

» Asset-Specific Reserve (ASC 310-10-35/ FAS114) » Estimate periodic cash flows and discount at contract rate of interest.

̵ Large exposures: Estimate on a scenario basis ̵ Smaller exposures: Estimate conditional probability of remaining on non- accrual, given amount of time already on non-accrual-from historical data

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25 FASB Impairment Standards and ALLL, October 2013

Considerations for estimating PD as it relates to the estimate of EL for allowance purposes

» Expected Losses= PD x LGD x EAD over contractual term » Contractual term could be shortened based on expected prepayment (“expected life”) » PD could be developed from historical data associated with current rating status incorporating transitions to other ratings » Evaluate Expected Default Frequency (EDFs) (PIT) vs. (TTC) PDs » Expressed as cumulative PD over expected life

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26 FASB Impairment Standards and ALLL, October 2013

Similarly, the estimate of LGD for loan loss reserving has unique attributes unto itself

» LGDs for allowance are different from LGDs for regulatory capital » Not downturn LGDs » Exclude workout costs » Exclude AIR (accrued interest receivable) » Can use overall average discount rate, possibly based on contractual rate

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27 FASB Impairment Standards and ALLL, October 2013

There are also several treatment options for EAD

» EAD for on-balance sheet exposures = outstanding balance » EAD for revolving credits based on unused portion » Add Loan Equivalent (LEQ) factor to EAD » Can either include this in the Allowance for Loan Loss Reserves

r Allowance for Lending – Related Commitments

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28 FASB Impairment Standards and ALLL, October 2013

Historical averages alone may not be sufficient, warranting a credit risk adjustment to the EL

» Historical averages may not adequately consider the current point

r forecasted direction of the economic cycle

» Credit risk adjustment modifies the base EL to reflect reasonable and supportable forecasts about the collectability of future cash flows » Management evaluates the current point in the economic cycle, as well as other important current credit indicators such as borrower behavior and collateral values, how current underwriting standards compare with those in the base EL, and recent trends in economic conditions

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Historical variability of PDs

Historical Rating agency data Aaa Aa A Baa Ba B Caa Mean PD 0% 0.01% 0.03% 0.21% 1.12% 5.16% 22.56% One Standard Deviation 0% 0.08% 0.08% 0.31% 1.11% 3.47% 16.49% Coefficient of Variation CV= s/m) 0% 0% 200% 146% 99% 67% 73% LEQ Distribution 6% 4% 25% 30% 20% 10% 5% Weighted average upper bound (1s/m) 120% Weighted average lower bound (0.5s/m) 60%

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30 FASB Impairment Standards and ALLL, October 2013

Construct scorecard

» Factors to be considered: » Portfolio regional and industry concentrations » Current point in economic cycle (PIT vs. TTC indicators---Credit Edge and RiskCalc) » Forecast of macro factors » Underwriting characteristics of current portfolio

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31 FASB Impairment Standards and ALLL, October 2013

Apply scorecard result to range

a1F1 a2F2 a2F3 a4F4 a5F5 a6F6

EL+120%EL EL-60%EL

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32 FASB Impairment Standards and ALLL, October 2013

Fed Reserve Survey Lending Standards

Report covers the percentage of firms surveyed who state that their lending standards were tighter in the current quarter vs. prior quarter

20 40 60 80 100 1990Q2 1990Q4 1991Q2 1991Q4 1992Q2 1992Q4 1993Q2 1993Q4 1994Q2 1994Q4 1995Q2 1995Q4 1996Q2 1996Q4 1997Q2 1997Q4 1998Q2 1998Q4 1999Q2 1999Q4 2000Q2 2000Q4 2001Q2 2001Q4 2002Q2 2002Q4 2003Q2 2003Q4 2004Q2 2004Q4 2005Q2 2005Q4 2006Q2 2006Q4 2007Q2 2007Q4 2008Q2 2008Q4 2009Q2 2009Q4 2010Q2 2010Q4 2011Q2 2011Q4 2012Q2

Fed Survey of Net Tightening Standards

Net(Tight-Loose) Stds Previous Qtr

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33 FASB Impairment Standards and ALLL, October 2013

Charge-offs follow tightening

0.5 1 1.5 2 2.5 3

Tighter Lending Standards Lead C & I Chargeoffs by 1 year

Net(Tight-Loose) Stds Previous Qtr ChgOff Rates 1 Yr later

Adjusted R2 = 82%

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Covenant quality index

» Historical information on covenant quality can also help determining underwriting standards embedded in current portfolio (e.g., change of control, structural subordination, cash leakage, leveraging) » Moody‟s covenant quality index: score summarizes protection to bond holders ranging - CQ1 (strong) to CQ5 (weak)

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Moody‟s covenant quality

3.00 3.20 3.40 3.60 3.80 4.00 4.20 4.40 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13

Covenant Quality Index

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Stress Testing and Reserves

4

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Stress testing and Reserves

» Stress testing (CCAR) evaluates impact of macroeconomic factors on bank profitability and on regulatory capital ratios » Stress tests have an impact on increased PDs, accelerating downward rating transitions, higher loss severities, and increased likelihood of draw down on unused commitments » Maximum losses obtained from stress tests should be significantly above the maximum credit risk adjustment

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38 FASB Impairment Standards and ALLL, October 2013

Credit portfolio migration under stress

0.05 0.1 0.15 0.2 0.25 Risk Rating 1 2 3 4 5 6 7 8 9 10 Loss Rating Distribution

Credit Portfolio Migration Under Stress

Base Credit Expected Recession

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39 FASB Impairment Standards and ALLL, October 2013

Reserve requirement under stress

500 1000 1500 2000 2500 Risk Rating 1 2 3 4 5 6 7 8 9 10 Reserves

Reserve Requirement Under Stress

Expected Recession

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RAROC considerations

» Economic capital and risk adjusted return on economic capital has been the guiding criteria since the mid-90s as portfolio measurement and management have advanced

– EDF measures (CreditEdge/Credit Monitor/RiskCalc) – Portfolio models (Risk Frontier/Portfolio Manager)

» Regulatory capital, stress tests, and liquidity measures now serve as constraints on return on economic capital objectives » As Loan Loss Reserve changes become implemented, care needs to be taken that these are not part of RAROC decisions

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Questions?

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42 FASB Impairment Standards and ALLL, October 2013

» Christian Henkel Director Moody’s Analytics Enterprise Risk Solutions christian.henkel@moodys.com +1.212.553.4679

moodys.com

» Mich Araten Managing Director Credit Risk Capital Advisory araten@aol.com +1.914.428.6173