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.
Comments
Sir:
The global financial crisis and the subsequent recession can be attributed in one word to "greed". All models fail when human greed gets the better of human need. The area of finance has its principles rooted in conservatism. Yet, bank after bank has thrown this principle to the winds in trying to maximize short-term shareholder value. The crisis also highlights the limitations of free market economies. It is time for organizations to focus on long term value creation instead of being obsessed with the next quarter, month, week, day or hour. Also, it is important that the interests of all stakeholders be kept in mind and not merely shareholders. This requires re-defining the basic contours of business. The best organizations in the world have already realized this and their business models reflect the changed reality. The sooner other organizations, and indeed by extension, societies and nations, accept and adapt, the better it would be for humankind. At the end of the day, it is not mathematical or any other type of modelling that can really solve our problems. These tools would of course be helpful but ultimately there is no substitute for human judgment. As long as we can discriminate between societal good and plain selfishness, there is yet hope for humanity.
Warm regards
Posted by: Dr B V Krishnamurthy | November 13, 2009 8:26 AM
Manoj,
You have put in the right perspective. Also, I fully appreciate the views of Dr. Krishnamurthy. The short term approach and the pressure to deliver quarter after quarter and the concomitant mind boggling bonuses that are assosicated with performance is a sure fire recipe for disaster. Greed is the source of all ingenuity.
My voice (and indeed Dr. Krishnamurthy's) in this regard is still a minority. I sincerely hope the lessons of this crisis is learnt and learnt well.
Although i am yet to hear many such voices as far as proposed regulations go, I am an eternal optimist and am keeping my fingers crossed.
Warm regards,
Posted by: Kunal Kumar Kundu | November 16, 2009 6:52 AM
Dear Manoj,
This article is the need of the hour and forms core of the Financial Risk Management arena. I am pretty sure that lot of financial institutions will be using these kind of models going forward to sustain their business in these uncertain times. All the best for your future articles!!!
Regards,
Karthik
Posted by: Karthik Padmanabhan | November 25, 2009 9:45 AM