Application of Dynamic Loan Loss Provisioning Dr. Stephen W. Hiemstra International Monetary Fund February 28, 2011

Dr. Stephen W. Hiemstra 27 years of federal service as economist, credit examiner, and financial engineer. Special experience with agriculture and housing credit. USDA, FCA, OCC, OFHEO, FHFA. BS – Iowa State University, MS – Cornell University, Phd – Michigan State University.

DISCLAIMER The views expressed here are my own. They do not necessarily reflect the views or policies of my employers, present or past.

What are your objectives in loan loss provisioning?

Concern for prudent management? Response to crisis? Compliance exercise?

Definitions Provisioning focuses on establishing reserves to offset expected loan losses. Capital reserves focus on establishing reserves against unexpected loan losses. Expected losses focus on the mean of the loss distribution. Unexpected losses are the losses in excess of the mean measured by the variance around the mean.

Principles of Capital Regulation Focus on loss provisioning frequently allows more timely adjustment when credit losses problems arise. Prompt response to rising losses signals to managers to take other actions to mitigate losses. Full capitalization of risks against a systemic crisis is too costly to be practical. Part of the problem with capital is tax policy and concern about manipulation of earnings.

Strategy in Estimating Loan Losses for Provisioning Limits on data, staff resources, and other practical problems typical dictate choice of the technique of estimation for provision. As such, the simplest procedures are applied first with more complex procedures being applied as time and resources allow. More complex methods permit stress modeling and forecasting to form robust expectations.

Estimation Strategies I TitleProcedureComments Usual methodManagement earnings targets are used to determine a provision level needed to achieve target. Management response in crisis is delayed raising loss levels. Potential for unrealistic provisioning leads to credibility problems. Typical bank method Losses in prior period determine provision in this period with a small increase to cover variance. This method serves well when losses build slowly. Frequency increases with bank size. Sophisticated firms break up by portfolios. Typical modeling Losses are projected for the portfolio typing historical records to external events. Usual focus is capital or failure probability, not loss provisioning. Tendency is to “manage” or ignore estimates.

Estimation Strategies II TitleProcedureComments Dynamic loss provisioning I Estimate losses from history for the portfolio as a whole. Focus is on the mean loss figure. Dynamic loss provision II Estimate losses for different loan status codes This refinement disaggregates for the loan status codes but retains focus on the mean loss figure. Dynamic loss provision IV Estimate losses for loan status code changes during period using constant shares of the cells in particular rows in the loan transition matrix. This method is relatively easy and provides reasonable estimates for months into future. Dynamic loss provision V Estimate equations for each cell in the loan transition matrix. This method is conceptually helpful but empirically challenging.

Discussion of Strategies Data quality, especially of the length of the data history and frequency of reporting, determine the prospects for using dynamic loan loss estimation. Failure probabilities can be used to develop non-parametric estimates of coefficients to apply while estimates are being developed.

Special Questions What kind of contracts are most typical in the portfolio? Are they monthly, quarterly, or annual pay? Are local industries well diversified or highly specialized? What are chief determinants of loan performance? (local employment, weather, trade, etc). How large are loans relative to lender capital?

IMPLICATIONS OF FINANCIAL CRISIS FOR SUPERVISORS?

IMPLICATIONS Systemic risk is a large share of total losses. International linkages can either dampen or amplify shocks originating in other countries. Provisioning needs to anticipate non-random loss structure. Systemic losses are too large to reserve against which implies provisioning must serve to signal other prudential measures.

THANK YOU! Questions?