Loss Reserving Approaches
In recent times, global financial markets are shaken by a credit crisis originating from U.S. mortgages. Some of the big banks including those with diversified portfolios with good track records have shown signs of eroding profits and credit crunch. This has brought the focus back on to the risk process adopted during last decade when the charge-offs were historically lower. As the audit process for loss forecasting are becoming more rigorous, bankers are finding their existing loss forecast process being either over simplistic or too complex to understand and validate. Hence a better method is needed which can incorporate historical information, economic trends and multi-model support without making it challenging to implement and maintain.
The loss forecasting models eventually are used to create a loss reserve for the bank. Banks today are being challenged with the credit losses looming large over their asset categories including credit card loans, real estate loans, auto loans, mortgages and others. In addition to their loan losses, banks also have to absorb their loss reserves. Loss reserve are generally used by banks for dealing with charge offs. The idea is to keep the bank safe and sound from bad loans. Additionally loss reserves helps in turning the economic cycle as it built up loss reserves anticipating higher future losses when the economic cycle turns negative. During bad times, it is able to extend credit thereby working as ‘countercyclical’. An economic or financial policy is called 'countercyclical' if it works against the cyclical tendencies in the economy. That is, countercyclical policies slow down the economy when in upswing, and stimulates it when in downturn.
However the current financial problem got magnified because the banks failed to follow the theory. Instead of building up reserves during upturn, banks failed to keep pace with the loan loss reserve ratios with outstanding. When the downturn started, to offset the losses, loss reserves started eating into banks capital thereby severely impacting its ability to remain functional. Instead of following countercyclical approach, the banks became ‘procyclical’. In procyclical approach, the bank’s credit policy and loss reserve practices moves in correlation with economic cycle. During upturn, banks advances loans for poor collaterals and low creditworthy customers (subprime). This contributes to rapid growth in credit lending, rise in collateral values and decrease in loss reserves. However during downturn, the bank becomes very stringent in credit lending and increases loss reserves which impacts its profitability and worsens its capital requirement. In extreme case, this behaviour can convert into an industry crisis.
