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5 Methods to Mitigate Risk in ALLL & Stress Testing

5 best practices that banks should incorporate in their risk management strategies.

As bankers wrap up the third quarter of 2014, they continue to encounter challenges in growing their loan portfolios and complying with ongoing regulatory changes. But according to several banking experts participating in the 3rd Annual Risk Management Summit, there are ways bankers can reduce examiner criticism and risk heading into 2015. Here are their five tips:

1. Develop an understanding of loan-level risk rating system requirements under Basel III. Basel III will have a significant impact on loan-level risk rating systems according to Crowe Horwath’s Dave Keever and Jack Gregory. Compliance will require significant loan level, portfolio, and enterprise-wide analytics, and to maintain best practices, they advise incorporating four key requirements:

  • A single rating grade for each obligor
  • The relevant historical data for Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD) estimation
  • Consistency with internal risk management processes
  • Periodic review and update of ratings

During their session at the risk management summit, Gregory and Keever will cover how to prepare for Basel III, including best practices for model development and model deployment platforms.

2. In your stress testing process, create a formalized “challenge” aspect. According to Liz Williams, managing director at CEIS Review, regulators and examiners are emphasizing the qualitative aspects of a bank’s stress testing process. Williams, who will discuss "Stress Testing -- What Examiners Expect and Emerging Best Practices" at the summit, added that governance and management “ownership” of the process are included in the qualitative aspects. To maintain best practices, it is recommended that bankers build a formalized process to review, question, or even challenge the data, framework, assumptions, process, and results of the stress test periodically.

[For more on stress testing best practices: Stress Testing: From Regulatory Burden to Catalyst for Business Transformation.]

3. Determine the effectiveness of your ALLL methodology. Given the increased scrutiny of determining a bank’s ALLL reserves by examiners, all involved in the process are looking for additional ways to measure the effectiveness of their methodology. Sageworks risk management consultant Aaron Lenhart says to consider backtesting a reserve on the portfolio as a good starting point. In a session on the topic, Lenhart will cover what questions a bank should ask to assess model accuracy, review different backtesting techniques at the portfolio and concentration level, and identify key challenges to be aware of.

4. Learn best practices of your peers by periodically identifying your ALLL challenges. According to Linda Keith, CPA, bankers should take structured time to target what is working and what should be improved in their ALLL processes. To create a list of the "Ten Essentials of the ALLL," she collaborated with risk management professionals across the country. Tools like this can be used to identify areas of strength and weakness and allow bankers to gain more insight from targeted conversations with peers. The "Ten Essentials" will be used by Keith to lead an interactive session at the summit.

5. Properly prepare for the move to migration analysis. Migration analysis is a more sophisticated approach for determining historical loss experience. For bankers not already performing migration analysis, Sageworks’ Tim McPeak says there are three ways for bankers to prepare:

  • Bolster your risk rating system
  • Set up processes to collect sufficiently granular data
  • Leverage industry resources, whitepapers, webinars, and seminars to improve understanding of the process

McPeak will lead a session at the summit on how to demystify migration analysis.

Before joining Sageworks as a research specialist, Mary Ellen Biery was a reporter for nearly 20 years, most recently for Dow Jones Newswires, where she covered breaking corporate financial news for the wire and for The Wall Street Journal. View Full Bio

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