Don’t Identify Risk - Quantify Risk!

Reserve methodologies of Credit Unions and other lenders vary based on sophistication, geo-economic environment, loan products and management of related risk characteristics. No matter the factors varying these institutions, key reserve procedures should include - the ability to evaluate loan risk regularly, a process for individual loans to be called out, access to current data and valuations, and the ability to identify areas of concentration by multiple attributes.

Risk managers agree that merely identifying risk is not enough. Flagging risk as an isolated exercise when credit scores or payment strings are updated is reactionary and can be too little, too late. It does not give the institution an opportunity to prepare and make adjustments, nor does it empower the institution to help the borrower. Isolated risk attributes do not indicate the existence of probable risk as compared to an expected loss approach which accounts for sensitivity to change and potential movement of the risk attributes.

The goal for most lenders is to employ a more proactive approach to calculate loan risk. Getting to the next level with a forward-looking methodology enables portfolio managers to quantify risk with probability of default (PD) and loss given default (LGD) at the loan level. This opportunity to stay ahead becomes more attractive as the expected loss information is used as a by-product to help with pricing, new campaigns and member loyalty.

The understanding and testing for changes, movement and sensitivity in risk characteristics proves insightful to estimating future loan performance. Quantifying risk at the loan level is actionable, more meaningful and can be applied to Loan Loss Reserves in anticipation of CECL as well as other areas of lending.

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