Best Practices in Credit Loss Modeling
Take a deeper look into Best Practices in Credit Loss Modeling through the presentation led by Douglas Winn and Matt Erickson at the 2016 Moss Adams Credit Union Conference.
Financial institutions face several balance sheet risks including credit, interest rate, and liquidity. Wilary Winn considers credit to be the most critical risk because losses incurred on loans and investments have been key factors in banking crises and failures.
We believe credit loss estimates are best made from the bottom up at the loan or cohort level, using discounted cash flow models based on the specific attributes of the financial asset such as type of loan, term, fixed or variable rate, combined with predictive credit indicators such as FICO and combined loan-to-value ratio. We also believe that bottom up analyses lead to more accurate estimates and that a DCF methodology is in full compliance with the proposed CECL standard. A bottom up approach has two additional advantages:
- Combining granular credit estimates with interest rate and liquidity risk modeling results in a thorough understanding of the primary balance sheet risks on an integrated basis leading to more robust capital stress tests and, ultimately, to better allocations of capital.
- Basing credit loss estimates on the same loan attributes and credit indicators lenders use to make loans can lead to better integration of lending and financial decision-making, including risk-based pricing and real-return analyses.