ACL Model Validation
Part II: Loan Portfolio Segmentation
By: Peter Warmenhoven, Consultant

Financial institutions have transitioned to the Current Expected Credit Loss, or “CECL” method of estimating the Allowance for Credit Losses. Following regulatory expectations, many financial institutions are evaluating the effectiveness of their CECL process and looking for ways to improve the accuracy of their CECL result.  One of the most basic yet important elements of the CECL process to evaluate is portfolio segmentation; the way institutions divide their loan portfolios into pools of loans with similar risk characteristics.  Proper segmentation is the foundation of an accurate ACL estimate.  From each loan segment, loss histories and loan lifetimes must be determined, cohorts can be identified, and relative qualitative adjustments are applied.

FASB ASC Topic 326, the CECL Standard, requires expected losses to be evaluated on a collective, or pool, basis when financial assets share similar risk characteristics. However, neither FASB nor the regulatory agencies have prescribed a specific process for segmenting financial assets into pools for collective evaluation. Depending on portfolio size, composition, and complexity, a pool segmentation that’s appropriate for one institution may not be appropriate for another.  While there is no definitive approach for an institution to segment its portfolio, the CECL Standard does provide these key guidelines:

• Segmentations or pools should have similar risk characteristics
• Pools should be as granular as possible while maintaining statistical significance
• Risk differentiation and economic responsiveness are key considerations
• Both credit and non-credit related characteristics are relevant
• Management should exercise judgment when establishing appropriate segments or pools
• Management should evaluate financial asset segmentation on an ongoing basis

Many institutions, especially community based financial institutions, have segmented their portfolios to some extent according to the Call Report Codes for Schedule RC-C, Loans and Leases.  For Call Report purposes, each institution’s loan portfolio is already segmented into standardized pools according to loan  purpose, collateral type, or borrower. The call code represents a common starting place that virtually all institutions already track.  After first segmenting by call code, CECL pools can be refined by other criteria to break out significant sub-pools, or even by combining segments into larger pools according to shared risk characteristics.

Granularity and significance (in terms of pool size) are often competing priorities and can present conflict when deciding on segmentation. While call report segments may provide a good starting point, digging deeper into loan system data may uncover risk characteristics that warrant further portfolio breakouts. But with more sub-segments, each loan pool becomes smaller and may start to lack significance. Management should exercise judgement to ensure a proper balance between identifying a segmentation that has sufficient granularity to produce a meaningful result. Again, there is no exact method to achieve a balance between granularity and significance.  The conflict in these priorities can be illustrated in a few examples:

• Bank A has a $500MM loan portfolio and primarily uses Call Report codes to segment loans for its ACL calculation. Bank A holds $75MM of loans secured by “Other nonfarm nonresidential properties” (call code 1.e.2.), which includes diverse income-producing property types such as hospitality, retail, office, and industrial properties. In drilling down on these property types after a period of economic stress, management noted that its loans secured by retail and hospitality properties incurred somewhat higher delinquency and loss rates than other property types. Bank A’s management observed that retail and hospitality property loans do not share risk characteristics equally with other 1.e.2. loans. As economic responsiveness is a key consideration in segmenting loan pools, and for its loan segments to be as granular as possible, Bank A should consider segmenting the retail and hospitality loans into a separate pool that reflects the higher risk. Bank A should also consider whether the new pool (and the remaining pool) is large enough to have statistical significance.
• In another example, Bank B has a $500MM loan portfolio and primarily uses Call Report codes to segment loans for its ACL calculation. Bank B holds $25MM of HELOC loans (call code 1.c.1.) as well as $8MM of Home Equity Term loans (call code 1.c.2.b.). The bank’s loss history in both segments is very comparable. As both loan types are secured by junior liens on residential real estate and have comparable loss history, Bank B’s management believes these loan types share similar risk characteristics. Bank B should consider combining these two Call Report segments into one segment for ACL purposes.
• Finally, Bank C has a $500MM loan portfolio and primarily uses Call Report codes to segment loans for its ACL calculation. One of the Bank’s more significant loan segments is owner-occupied commercial real estate (call code 1.e.1.), amounting to $50MM. Within this segment, Bank C has a number of SBA 504 loans, totaling $10MM and having an average loan/value of less than 50%. As the bank has never incurred a loss on an SBA 504 loan, Bank C’s management noted that this group has less inherent risk than other loans in the 1.e.1. segment because of the low LTVs. While SBA 504 loans generally may not share risk characteristics equally with other 1.e.1. loans, and for its loan segments to be as granular as possible, Bank C should consider segmenting the SBA 504 loans into a pool that reflects the reduced risk. Bank B must also decide whether the new pool is large enough to have statistical significance.

As set forth in the Interagency Policy Statement on Allowances for Credit Losses (Revised April 2023), “Management should evaluate financial asset segmentation on an ongoing basis to determine whether the financial assets in the pool continue to share similar risk characteristics.” An asset does not need to receive the same segmentation treatment throughout the asset’s life. Additionally, situations may arise when new or additional segments may be needed. Examples include the introduction of new products, significant changes to the bank’s underwriting standards or practices, or changes in repayment trends.

Lack of data availability is another reality that institutions must address. Loan accounting systems typically track loan data points such as loan type, purpose, collateral type, and borrower type. However, if your institution does not assign a call code to each loan at origination and includes that call code in loan system data, consider making that change in your booking process.

The interagency Policy Statement also states that Management should periodically validate the institution’s loss estimation process, to confirm that the process is appropriate for the institution’s size, complexity, and risk profile. The agencies’ expectation is that the validation process should include procedures for review by a party with appropriate knowledge and technical expertise, who is independent of the Bank’s credit and ACL process.

In 2023 and 2024, our ACL Validation service assisted numerous clients in validating their CECL methodologies and provided ongoing guidance for the ACL process. As the “new” accounting treatment approaches its first anniversary for many community-based financial institutions, some may not have undergone a regulatory review since its implementation, lacking regulatory insights into the ACL process.  An ACL Validation will help identify areas for improvement either prior to or in support of regulatory feedback.

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The Enduring Relevance: Exploring the Timelessness of the 5 C’s of Credit 

By: Kevin Graff

As we begin a new year, the financial landscape is evolving at an unprecedented pace. Despite the whirlwind of technological advancements and the ever-changing dynamics of the banking industry, there exists a set of principles that stand the test of time—The 5 C’s of Credit. In this blog, we delve into the enduring relevance of these timeless principles and their fundamental role in navigating the complexities of the financial realm. 

Timeless, as defined by Merriam-Webster, is not restricted to a certain time or date. The concept of timelessness can be applied to many factors involved in commercial lending. While technological advancements in credit underwriting can make complex and difficult financial analysis seem easy, the basic tenets of commercial lending remain steadfast. These central principles included within Character, Capacity, Collateral, Conditions, and Capital provide the foundation for nearly every lending decision.  

Character: The Foundation of Trust 
The first of the 5 C’s, Character, remains the bedrock of sound lending practices. In an era dominated by algorithms and data analytics, the assessment of an individual’s integrity, honesty, and reputation remains unparalleled. The timeless nature of character evaluation ensures that trust, a currency more valuable than ever, continues to be a cornerstone in lending decisions.  

Capacity: Navigating Financial Waters 
Capacity, the second C, addresses the borrower’s ability to repay a loan. Despite the advent of sophisticated financial models, the ability to understand and analyze an individual or business’s capacity to meet financial obligations remains a linchpin in prudent lending. This timeless principle involves both art and science as borrowers face a continuously evolving economic landscape, proving its relevance in diverse financial scenarios.  

Collateral: A Tangible Safety Net 
Collateral, the third C, provides a tangible safety net for lenders. While technological innovations have introduced new ways of assessing collateral value, the fundamental principle of understanding the various nuances of pledged assets remains steadfast. The ability to understand how collateral may be impacted by changing market conditions ensures that this timeless principle remains effective in mitigating risk.  

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Can you believe it? Five years have passed since we embarked on this incredible journey, and we couldn’t have done it without you. We are thrilled to celebrate our 5th year in business, and we want to take a moment to express our heartfelt gratitude for your support. This milestone not only represents our achievement but the trust and loyalty you’ve shown us throughout this adventure. 

 Our success story is incomplete without the remarkable people who have supported us from day one  — our customers. We want to extend our deepest gratitude to each one of you.  You are the reason we are here today, and we promise to keep exceeding your expectations.  

 And to our team – we want to extend our heartfelt appreciation to our consultants who have been a driving force in our success. experience, hard work, and dedication has allowed us to expand into five states across the Upper Midwest, serve over 50 financial institutions, review over 2,300 credit relationships, and almost $14 billion in total portfolio commitments.   

 As we celebrate this milestone, we’re not just looking back; we are also looking forward to the exciting journey ahead of us. We value your feedback, and we remain motivated to keep improving.  

 Our 5th-year anniversary is not just about our accomplishments; it’s a celebration of the relationships we’ve built and the community that surrounds us. Thank you for choosing us as your trusted partner, and here’s to many more years of growth, success, and shared moments. We look forward to continuing this next chapter with you! 

Reviewing real estate appraisals and evaluations can seem a mundane but required task in the commercial lending process.  The commercial appraisal and evaluation (valuation) review process[i] within community-based financial institutions includes internally prepared reviews, third-party prepared reviews, or some combination of the two.  Often, the internally prepared review is completed by less experienced financial institution staff as a part of their training process, while some institutions have a dedicated appraisal and review department.  Loan officers may also perceive the review as a necessary evil rather than a risk management function.  The significance of the appraisal or evaluation review should be considered as a part of the pre-funding due diligence and risk management process, however pedestrian the process may seem.

Valuation reviews are a standard and vital part of a loan file review for commercial real estate lending transactions.  Recently our loan review activities identified two situations where the compliance review completed by the financial institution did not identify material flaws with the information included in the appraisal.   Both circumstances originated with a flawed appraisal engagement letter which did not appropriately identify the subject property.  The reviews of these valuations did not detect the mismatch between the appraised property and the property identified in the credit approval pledged to secure the transaction.  The result of the deficient appraisal review led to lending decisions using market values that did not represent the collateral pledged.

[i] The Uniform Standards of Professional Appraisal Practice (USPAP) 2010-2011 edition defines an appraisal review as the act or process of developing and communicating an opinion about the quality of another appraiser’s work that was performed as part of an appraisal, appraisal review, or appraisal consulting assignment. In addition, Section 1473(e) of the Dodd-Frank Act amended Section 1110 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 to require the federal financial regulatory agencies, Federal Housing Finance Agency (FHFA), and Consumer Financial Protection Bureau (CFPB) to issue appraisal review standards.

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