ALLL Best Practices

ALLL Best Practices:Stress Testing and Economic Factor Consideration

Tuesday, June 18, 2013 10:15am – 11:15am

Presented by:

www.fmsinc.org | 800-ASK-4FMS

Presented by:

Jamie SumnerChief Analyst

Kyle KusterSenior Analyst

Seifried & Brew, LLC817 West Broad StreetBethlehem, Pennsylvania 18018

slide 1

Why Perform a Stress Test?

• Because you have to!• Because you want to better understand

your risk.• Because you want to set some trigger

points.• Because you want to identify any risk

concentrations that you need tomitigate.


• Because you have to!• Because you want to better understand

your risk.• Because you want to set some trigger

points.• Because you want to identify any risk

concentrations that you need tomitigate.

slide 2

When to Perform the Stress Test?

• At least annually.• In conjunction with your capital plan

and/or strategic plan.• When you want to add a significant

amount of loans.• When looking to change the structure of

the balance sheet.


• At least annually.• In conjunction with your capital plan

and/or strategic plan.• When you want to add a significant

amount of loans.• When looking to change the structure of

the balance sheet.

slide 3

OCC Expectations/Guidelines

• October 2012 Bulletin (OCC 2012-33)• While banks with assets >$10 Billion are required to

prepare in-depth stress tests, community banks areencouraged to do so.

• Stress testing can be used to establish and supportreasonable risk appetite and tolerances, setconcentration limits, adjust strategies, andappropriately plan for and maintain adequate capitallevels.

• Results of the stress test should be used to prepareaction plans to mitigate risk outside of the bank’stolerance levels.


• October 2012 Bulletin (OCC 2012-33)• While banks with assets >$10 Billion are required to

prepare in-depth stress tests, community banks areencouraged to do so.

• Stress testing can be used to establish and supportreasonable risk appetite and tolerances, setconcentration limits, adjust strategies, andappropriately plan for and maintain adequate capitallevels.

• Results of the stress test should be used to prepareaction plans to mitigate risk outside of the bank’stolerance levels.

slide 4

Types of Stress Tests

• Transaction stress testing– Individual loan level analysis– Drill down or bottom-up analysis

• Portfolio stress testing– Used in conjunction with the transaction stress test– “Top-down” approach uses broad categories of loans

with respective loss rates• Enterprise-level stress testing

– Incorporates other types of risk into the analysis, suchas interest rate risk, liquidity risk and/or counter-partyrisk.

• Reverse stress testing– “break the bank” scenario


• Transaction stress testing– Individual loan level analysis– Drill down or bottom-up analysis

• Portfolio stress testing– Used in conjunction with the transaction stress test– “Top-down” approach uses broad categories of loans

with respective loss rates• Enterprise-level stress testing

– Incorporates other types of risk into the analysis, suchas interest rate risk, liquidity risk and/or counter-partyrisk.

• Reverse stress testing– “break the bank” scenario

slide 5

“For most community banks, a simple,stressed loss-rate analysis based on callreport categories may provide aacceptable foundation to determine ifadditional analysis is necessary.”

(OCC 2012-33 )


“For most community banks, a simple,stressed loss-rate analysis based on callreport categories may provide aacceptable foundation to determine ifadditional analysis is necessary.”

(OCC 2012-33 )

slide 6

“If the stress test reveals critical vulnerabilities,management and the board should take steps tomitigate those risks through such means asmodifying loan growth, revising the risk tolerancestrategy, adjusting the portfolio mix andunderwriting criteria, altering concentration limitsor other policies and procedures, and strengtheningcapital.”(OCC 2012-33)


“If the stress test reveals critical vulnerabilities,management and the board should take steps tomitigate those risks through such means asmodifying loan growth, revising the risk tolerancestrategy, adjusting the portfolio mix andunderwriting criteria, altering concentration limitsor other policies and procedures, and strengtheningcapital.”(OCC 2012-33)

slide 7

Common Elements of a StressTest

• Two-year projection• Incorporates a “Base” and “Adverse”

scenarios• Plausible “What If” questions• Quantify the impact to earnings and

capital• Incorporate the results into the

management of the bank


• Two-year projection• Incorporates a “Base” and “Adverse”

scenarios• Plausible “What If” questions• Quantify the impact to earnings and

capital• Incorporate the results into the

management of the bankslide 8

Trend in Noncurrent Loans


slide 9

Trend in ALLL and Net Charge-offs


slide 10

National Historical Loss Rates(Average Loss Rates Per Year)

2002-2003 2010-2011Construction 0.15% 4.44%First Lien Mortgages 0.17% 1.59%Second/Junior Lien Mortgages

Closed-end Junior Liens 0.17% 1.59%HELOCs 0.20% 2.40%

Multifamily 0.05% 1.16%CRE 0.14% 1.06%C&I Loans 1.50% 1.27%Credit Card 5.95% 7.92%Other Consumer 1.45% 1.97%Other Loans 0.48% 0.45%


2002-2003 2010-2011Construction 0.15% 4.44%First Lien Mortgages 0.17% 1.59%Second/Junior Lien Mortgages

Closed-end Junior Liens 0.17% 1.59%HELOCs 0.20% 2.40%

Multifamily 0.05% 1.16%CRE 0.14% 1.06%C&I Loans 1.50% 1.27%Credit Card 5.95% 7.92%Other Consumer 1.45% 1.97%Other Loans 0.48% 0.45%

slide 11

2009 Federal Reserve Credit RiskStress Test


slide 12

Most Recent Stress Test ResultsReleased by the Federal Reserve

Q4 2012- Q4 2014Loss Rates

Domestic First-lien Morgages 6.60%Junior Liens and HELOCs 9.60%Commercial and Industrial 6.80%Comercial Real Estate 8.00%Credit Cards 16.70%Other consumer 6.10%Other Loans 1.80%Total Loans 7.50%


Q4 2012- Q4 2014Loss Rates

Domestic First-lien Morgages 6.60%Junior Liens and HELOCs 9.60%Commercial and Industrial 6.80%Comercial Real Estate 8.00%Credit Cards 16.70%Other consumer 6.10%Other Loans 1.80%Total Loans 7.50%

slide 13

Sample BankStress Test


Sample BankStress Test

slide 14

Sample Bank Loan Mix

Loan Quality by Loan Type ($000) Past Due and Nonaccrual

Loan Type

2013Q1Loan

Balance 30-90 days 90+ Days NonaccrualCurrent and

Performing Balance

Construction & Land Development 1,432 0 0 0 1,432Total 1-4 Family Loans 22,077 70 0 182 21,825

Total Closed-End 1-4 Family 21,506 70 0 182 21,254Closed-End First Lien 1-4 19,924 70 0 117 19,737Closed-End Jr Lien 1-4 1,582 0 0 65 1,517

Revolving 1-4 Family Loans (HE Lines) 571 0 0 0 571Multifamily Loans 3,053 0 0 0 3,053Commercial RE Loans (Nonfarm/NonRes) 39,180 668 0 205 38,307

Total Real Estate Loans 65,742 738 0 387 64,617

Commercial & Industrial Loans 16,248 174 0 311 15,763Credit Card Loans 0 0 0 0 0Other Consumer Loans (Incl Rev) 2,266 2 0 29 2,235Other Loans 14,091 32 0 0 14,059

Total Non-Real Estate Loans 32,605 208 0 340 32,057

Gross Loans & Leases 98,347 946 0 727 96,674


Loan Quality by Loan Type ($000) Past Due and Nonaccrual

Loan Type

2013Q1Loan

Balance 30-90 days 90+ Days NonaccrualCurrent and

Performing Balance

Construction & Land Development 1,432 0 0 0 1,432Total 1-4 Family Loans 22,077 70 0 182 21,825

Total Closed-End 1-4 Family 21,506 70 0 182 21,254Closed-End First Lien 1-4 19,924 70 0 117 19,737Closed-End Jr Lien 1-4 1,582 0 0 65 1,517

Revolving 1-4 Family Loans (HE Lines) 571 0 0 0 571Multifamily Loans 3,053 0 0 0 3,053Commercial RE Loans (Nonfarm/NonRes) 39,180 668 0 205 38,307

Total Real Estate Loans 65,742 738 0 387 64,617

Commercial & Industrial Loans 16,248 174 0 311 15,763Credit Card Loans 0 0 0 0 0Other Consumer Loans (Incl Rev) 2,266 2 0 29 2,235Other Loans 14,091 32 0 0 14,059

Total Non-Real Estate Loans 32,605 208 0 340 32,057

Gross Loans & Leases 98,347 946 0 727 96,674

slide 15

Sample Bank Trend inNet Charge-offs/Total Loans


slide 16

Sample Bank Stress Test Results(Historical Loss-Rate Scenario)

Loans ($000) 2002/2003 2010/20112013Q1 Total Commercial Banks Total Commercial Banks

% of Product $000 % of Product $000Construction 1,432 0.31% 4 8.88% 127First Lien Mortgages 19,737 0.33% 65 3.18% 627Second/Junior Lien Mortgages 2,088 0.35% 7 3.62% 76

Closed-end Junior Liens 1,517 0.33% 5 3.18% 48HELOCs 571 0.39% 2 4.81% 27

Multifamily 3,053 0.11% 3 2.32% 71CRE 38,307 0.28% 107 2.11% 809C&I Loans 15,763 3.00% 473 2.55% 402Credit Card - 11.90% - 15.84% -Other Consumer 2,235 2.91% 65 3.94% 88Other Loans 14,059 0.96% 136 0.90% 127Total Current & Performing Loans 96,674 0.89% 861 2.41% 2,326

Nonaccrual and 90+ past due 727 50% 364 50% 364Loan Past Due 30-89 days 946 25% 237 25% 237Total Loans 98,347

Total Estimated Net Charge-offs 1.49% 1,461 2.98% 2,926


Loans ($000) 2002/2003 2010/20112013Q1 Total Commercial Banks Total Commercial Banks

% of Product $000 % of Product $000Construction 1,432 0.31% 4 8.88% 127First Lien Mortgages 19,737 0.33% 65 3.18% 627Second/Junior Lien Mortgages 2,088 0.35% 7 3.62% 76


Multifamily 3,053 0.11% 3 2.32% 71CRE 38,307 0.28% 107 2.11% 809C&I Loans 15,763 3.00% 473 2.55% 402Credit Card - 11.90% - 15.84% -Other Consumer 2,235 2.91% 65 3.94% 88Other Loans 14,059 0.96% 136 0.90% 127Total Current & Performing Loans 96,674 0.89% 861 2.41% 2,326


Total Estimated Net Charge-offs 1.49% 1,461 2.98% 2,926slide 17

Sample Bank Stress Test Results(Historical Loss-Rate Scenario)

Cumulative Impact2002/2003 2010/2011

Estimated Net Charge-offs2002/2003 Case (1.49% of Total Loans) 1,4612010/2011 Case (2.98% of Total Loans) 2,926

Equity ImpactPre-tax, Pre-Provision Earnings - 2.00 years 3,136 3,089Less: Provisioning Expense ( LLR/TL Target of 1.30%) 1,445 2,910Pre-tax Net Income 1,692 179Tax Expense/(Benefit) [Tax rate of 28.00%] 474 50Net Income 1,218 129Less: Aggregate Dividend Burden - 2.00 years 0 0Total Impact to Equity 1,218 129

ActualCapital Ratio 2013Q1 Pro Forma Pro Forma

Equity/Assets 7.92% 8.83% 8.02%Tangible Common Equity/Tangible Assets 7.92% 8.83% 8.02%Leverage Capital Ratio (Tier 1/Avg Assets) 7.58% 8.45% 7.67%Tier 1 Capital Ratio (Tier 1/RWA) 10.39% 11.59% 10.52%Total Capital Ratio (RBC/RWA) 11.64% 12.84% 11.77%


Cumulative Impact2002/2003 2010/2011

Estimated Net Charge-offs2002/2003 Case (1.49% of Total Loans) 1,4612010/2011 Case (2.98% of Total Loans) 2,926

Equity ImpactPre-tax, Pre-Provision Earnings - 2.00 years 3,136 3,089Less: Provisioning Expense ( LLR/TL Target of 1.30%) 1,445 2,910Pre-tax Net Income 1,692 179Tax Expense/(Benefit) [Tax rate of 28.00%] 474 50Net Income 1,218 129Less: Aggregate Dividend Burden - 2.00 years 0 0Total Impact to Equity 1,218 129



slide 18

Sample Bank Stress Test Results(2009 Federal Reserve IndicativeLoss Rate)

Loans ($000) Federal Reserve System Federal Reserve System2013Q1 Baseline Losses More Adverse Losses

% of Product $000 % of Product $000Construction 1,432 10.00% 143 16.50% 236First Lien Mortgages 19,737 5.50% 1,086 7.75% 1,530Second/Junior Lien Mortgages 2,088 15.72% 328 19.81% 414


Multifamily 3,053 5.00% 153 10.50% 321CRE 38,307 4.50% 1,724 8.00% 3,065C&I Loans 15,763 3.50% 552 6.50% 1,025Credit Card - 15.00% - 19.00% -Other Consumer 2,235 5.00% 112 10.00% 224Other Loans 14,059 3.00% 422 7.00% 984Total Current & Performing Loans 96,674 4.67% 4,519 8.07% 7,797


Total Estimated Net Charge-offs 5.20% 5,119 8.54% 8,397


Loans ($000) Federal Reserve System Federal Reserve System2013Q1 Baseline Losses More Adverse Losses

% of Product $000 % of Product $000Construction 1,432 10.00% 143 16.50% 236First Lien Mortgages 19,737 5.50% 1,086 7.75% 1,530Second/Junior Lien Mortgages 2,088 15.72% 328 19.81% 414


Multifamily 3,053 5.00% 153 10.50% 321CRE 38,307 4.50% 1,724 8.00% 3,065C&I Loans 15,763 3.50% 552 6.50% 1,025Credit Card - 15.00% - 19.00% -Other Consumer 2,235 5.00% 112 10.00% 224Other Loans 14,059 3.00% 422 7.00% 984Total Current & Performing Loans 96,674 4.67% 4,519 8.07% 7,797


Total Estimated Net Charge-offs 5.20% 5,119 8.54% 8,397slide 19

Sample Bank Stress Test Results(2009 Federal Reserve IndicativeLoss Rate)

Cumulative ImpactBaseline More Adverse

Estimated Net Charge-offsBaseline (5.20% of Total Loans) 5,119More Adverse (8.54% of Total Loans) 8,397

Equity ImpactPre-tax, Pre-Provision Earnings - 2.00 years 3,010 2,978Less: Provisioning Expense ( LLR/TL Target of 1.30%) 5,102 8,380Pre-tax Net Loss (2,093) (5,402)Tax Expense/(Benefit) [Tax rate of 28.00%] (586) (1,513)Net Loss (1,507) (3,890)Less: Aggregate Dividend Burden - 2.00 years 0 0Total Impact to Equity (1,507) (3,890)




Cumulative ImpactBaseline More Adverse

Estimated Net Charge-offsBaseline (5.20% of Total Loans) 5,119More Adverse (8.54% of Total Loans) 8,397

Equity ImpactPre-tax, Pre-Provision Earnings - 2.00 years 3,010 2,978Less: Provisioning Expense ( LLR/TL Target of 1.30%) 5,102 8,380Pre-tax Net Loss (2,093) (5,402)Tax Expense/(Benefit) [Tax rate of 28.00%] (586) (1,513)Net Loss (1,507) (3,890)Less: Aggregate Dividend Burden - 2.00 years 0 0Total Impact to Equity (1,507) (3,890)


Equity/Assets 7.92% 6.81% 5.04%Tangible Common Equity/Tangible Assets 7.92% 6.81% 5.04%Leverage Capital Ratio (Tier 1/Avg Assets) 7.58% 6.50% 4.79%Tier 1 Capital Ratio (Tier 1/RWA) 10.39% 8.91% 6.56%Total Capital Ratio (RBC/RWA) 11.64% 10.16% 7.81%slide 20

Sample Bank Stress Test Results(Reverse Scenario)

Cumulative ImpactNo Charge-offs Well-Capitalized 1% Buffer

Estimated Net Charge-offsNet Charge-offs 0 5,344 4,025% of Loans 0.00% 5.43% 4.09%

Equity ImpactPre-tax, Pre-Provision Earnings - 2.00 years 3,168 3,010 3,105Less: Provisioning Expense ( LLR/TL Target of 1.30%) (17) 5,328 4,008Pre-tax Net Income/(Loss) 3,185 (2,318) (904)Tax Expense/(Benefit) [Tax rate of 28.00%] 892 (649) (253)Net Income/(Loss) 2,293 (1,669) (651)Less: Aggregate Dividend Burden - 2.00 years 0 0 0Total Impact to Equity 2,293 (1,669) (651)

ActualCapital Ratio 2013Q1 Pro Forma Pro Forma Pro Forma

Equity/Assets 7.92% 9.62% 6.69% 7.44%Tangible Common Equity/Tangible Assets 7.92% 9.62% 6.69% 7.44%Leverage Capital Ratio (Tier 1/Avg Assets) 7.58% 9.23% 6.38% 7.11%Tier 1 Capital Ratio (Tier 1/RWA) 10.39% 12.65% 8.75% 9.75%Total Capital Ratio (RBC/RWA) 11.64% 13.90% 10.00% 11.00%


Cumulative ImpactNo Charge-offs Well-Capitalized 1% Buffer

Estimated Net Charge-offsNet Charge-offs 0 5,344 4,025% of Loans 0.00% 5.43% 4.09%

Equity ImpactPre-tax, Pre-Provision Earnings - 2.00 years 3,168 3,010 3,105Less: Provisioning Expense ( LLR/TL Target of 1.30%) (17) 5,328 4,008Pre-tax Net Income/(Loss) 3,185 (2,318) (904)Tax Expense/(Benefit) [Tax rate of 28.00%] 892 (649) (253)Net Income/(Loss) 2,293 (1,669) (651)Less: Aggregate Dividend Burden - 2.00 years 0 0 0Total Impact to Equity 2,293 (1,669) (651)

ActualCapital Ratio 2013Q1 Pro Forma Pro Forma Pro Forma

Equity/Assets 7.92% 9.62% 6.69% 7.44%Tangible Common Equity/Tangible Assets 7.92% 9.62% 6.69% 7.44%Leverage Capital Ratio (Tier 1/Avg Assets) 7.58% 9.23% 6.38% 7.11%Tier 1 Capital Ratio (Tier 1/RWA) 10.39% 12.65% 8.75% 9.75%Total Capital Ratio (RBC/RWA) 11.64% 13.90% 10.00% 11.00%

slide 21

How Many Community Bank’sPass the “KISS” Test?

More than 75%!


More than 75%!

slide 22

Stress Testing and Management ofALLL

• Start at a high level and drill down ifneeded.

• Stress testing enables you to determinethe adequacy of your current ALLLbalance.

• Consider external factors to helpstrengthen your ALLL methodology.


• Start at a high level and drill down ifneeded.

• Stress testing enables you to determinethe adequacy of your current ALLLbalance.

• Consider external factors to helpstrengthen your ALLL methodology.

slide 23

Challenges of FAS 5• Conflicting guidance• Limited commentary

– See Commercial Bank Examination Manual– NCUA presentations and guidance– Philadelphia Fed Insights– Boston Fed Handout– St. Louis Fed Insights for Bank Directors


• Conflicting guidance• Limited commentary

– See Commercial Bank Examination Manual– NCUA presentations and guidance– Philadelphia Fed Insights– Boston Fed Handout– St. Louis Fed Insights for Bank Directors

slide 24

Part 1: FAS 5 Calculation:Segmenting the Portfolio

• Management should segment the loanportfolio by identifying risk characteristics thatare common to groups of loans.

• Individual loans judged as not impaired underFAS 114 will be included in their respectivegroups for evaluation under FAS 5.


• Management should segment the loanportfolio by identifying risk characteristics thatare common to groups of loans.

• Individual loans judged as not impaired underFAS 114 will be included in their respectivegroups for evaluation under FAS 5.

slide 25

Part 1: FAS 5 Calculation:Segmenting the Portfolio

• “[S]mall institutions often segment theportfolio into broad loan categories.”

• “[L]arger institutions typically have informationavailable to segment down to product-lines.”


• “[S]mall institutions often segment theportfolio into broad loan categories.”

• “[L]arger institutions typically have informationavailable to segment down to product-lines.”

slide 26

Part 1: FAS 5Calculations

• Divide and analyze your portfolio into loancategories.

• Basic call report categories should be fine forinstitutions with “less complex” products.

• Review historical loss rates for each category– 12-month?– 24-month?– 36-month!?


• Divide and analyze your portfolio into loancategories.

• Basic call report categories should be fine forinstitutions with “less complex” products.

• Review historical loss rates for each category– 12-month?– 24-month?– 36-month!?

slide 27

Part 1: FAS 5Calculations

• Example FL Group Loss Rates12-month 24-month 36-month

Residential RE 0.16% 0.26% 0.35%Commercial RE 0.17% 0.22% 0.26%


0.17% 0.22% 0.26%Construction/Dev 0.72% 0.94% 1.30%Multi Family 0.11% 0.19% 0.37%Farm 0.33% 0.33% 0.37%Commercial/Industrial 0.16% 0.21% 0.31%Consumer Loans 0.26% 0.30% 0.36%

slide 28

Part 2: External FactorsExternal factors “should take intoconsideration all available informationexisting as of the financial statement date,including environmental factors such asindustry, geographical, economic and politicalfactors.”


External factors “should take intoconsideration all available informationexisting as of the financial statement date,including environmental factors such asindustry, geographical, economic and politicalfactors.”

slide 29

Part 2: ExternalFactors

• What to use?• Where to find them?• Anecdotal Information/Evidence?

– Articles– Commentary– Economic reports


• What to use?• Where to find them?• Anecdotal Information/Evidence?

– Articles– Commentary– Economic reports

slide 30

External/EconomicFactors to Consider

• Unemployment• Housing Starts• ISM Manufacturing• Home Prices• Governmental Spending• Consumer Confidence• GDP• Inflation• Interest Rate Environment


• Unemployment• Housing Starts• ISM Manufacturing• Home Prices• Governmental Spending• Consumer Confidence• GDP• Inflation• Interest Rate Environment

slide 31

External/EconomicFactors to Consider

• Can we simplify this?– Coincident Index

– Nonfarm payroll– Average hours worked in manufacturing– Unemployment rate– Wage and salary disbursements deflated by CPI

• Diffusion index


• Can we simplify this?– Coincident Index

– Nonfarm payroll– Average hours worked in manufacturing– Unemployment rate– Wage and salary disbursements deflated by CPI

• Diffusion index

slide 32

Prove an ExternalFactor Model

• Can we simplify this?– Leading Index

• “The leading index for each state predicts the six-month growth rate of the state’s coincident index.”

• State-level housing permits (1-4 units)• State initial jobless claims• Delivery times from ISM• Interest rate spread


• Can we simplify this?– Leading Index

• “The leading index for each state predicts the six-month growth rate of the state’s coincident index.”

• State-level housing permits (1-4 units)• State initial jobless claims• Delivery times from ISM• Interest rate spread

slide 33

Your Thoughts?December 2008


slide 34

Prove an ExternalFactor Model

• Reliable• Consistent• Applicable

• Regressing Charge-offs with Economic Data• Net Charge-offs vs Leading Index (among

other factors)


• Reliable• Consistent• Applicable

• Regressing Charge-offs with Economic Data• Net Charge-offs vs Leading Index (among

other factors)

slide 35

Our Example• Data analyzed during two recessions

– (2000-2012)• Goal is to smooth out recessionary periods by

preemptively increasing/decreasing allowances• Produce an in-house factor to increase or

decrease ALLL by using a tested data set inconjunction with the loss rates of 12-months or24-months


• Data analyzed during two recessions– (2000-2012)

• Goal is to smooth out recessionary periods bypreemptively increasing/decreasing allowances

• Produce an in-house factor to increase ordecrease ALLL by using a tested data set inconjunction with the loss rates of 12-months or24-months

slide 36

Predictive Data


slide 37

Another Approach• Credit Risk

– Monitor Similar or Geo-centric banks forcredit risk

www.fmsinc.org | 800-ASK-4FMSslide 38

Truly the Best Practice

1. Crowdsource2. Share3. Implement


1. Crowdsource2. Share3. Implement

slide 39

Questions?


Questions?

slide 40

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